17/1/17: Government Debt in the Age of Austerity

The fact that the world is awash with debt is hard to dispute (see data here and here), but it is quite commonly argued that the aggressive re-leveraging happening in the corporate and household sectors runs contrary to the austerity trends in the public debt segment of the total economic debt. The paradox of the austerity arguments is, of course, that whilst debt is rising, public investment is falling and public consumption remains either stagnant of rising slowly. This should see public debt either declining or remaining static. Of course, banks bailouts in a number of advanced economies would have resulted in an uplift in public debt during the early years of the Global Financial Crisis and the Great Recession, but these years behind us, we should have witnessed the austerity translating into moderating debt levels in the global economy when it comes to public debt.

Alas, this is not the case, as illustrated in the chart below:

Here's a tricky bit:

• In the 5 years 2012-2016 (post-onset of the recovery) Government debt around the world rose 11.4% in level terms (USD), and 14.51 percentage points as a share of GDP per capita. During the crisis years of 2007-2011, Government debt rose 72.7% in dollar terms and was down 4.39 percentage points as a share of GDP.
• In the advanced economies, Government debt rose 67.6% in dollar terms in 2007-2011 period, up 4.7 percentage points, before rising 5.44% in dollar terms over subsequent 5 years (up 26.65 percentage points in terms of debt to GDP ratio). 
• In the euro area, Government debt was up 57.4% in dollar terms and up 0.51 percentage points in GDP ratio terms over the period of 2007-2011, before falling 6.9 percent in dollar terms but rising 24.8 percentage points relative to GDP in 2012-2016 period.
• And so on...

As the above chart shows, globally, total volume of Government debt was estimated to be USD63.2 trillion at the end of 2016, up USD6.46 trillion on the end of 2011. That is almost 84.1% of the world GDP today, as opposed to 78% of GDP at the end of 2011. More than half of this increase (USD3.91 trillion) came from the Emerging and Developing Economies, and USD2.3 trillion came from G7 economies. Meanwhile, euro area Government Debt levels declined USD815 billion, all of which was due solely to changes in the exchange rate and the rollover of some debt into multinational organisations' (e.g. ESM) and quasi-governmental (e.g. promissory notes) debt. Worse, over the said period of time, only one euro area country saw reduction in the levels of debt: Greece (down EUR34.46 billion due to restructuring of debt). In fact, in Euro terms, total euro area government debt rose some EUR1.36 trillion over the span of the 2011-2016 period.

All in, global pile of Government debt is now USD27.84 trillion (or 78.7%) up on where it was at the end of 2007 and the start of the Global Financial Crisis.

So may be, just may be, the real economy woe is that most of the new debt accumulated by the Governments in recent years has flown into waste (supporting banks, financial markets valuations, doling out subsidies to politically favoured sectors etc), instead of going to fund productive public investments, including education, skills training, apprenticeships and so on. Who knows?..

29/12/16: Drowning in Debt

Recently, I posted about the return - with a vengeance - of one of the key drivers of the Global Financial Crisis and the Great Recession, the rapid rise of the debt bubble across the global economy. The original post is available here: http://trueeconomics.blogspot.com/2016/12/161216-root-of-2007-2010-crises-is-back.html

There is more evidence of the problem reaching beyond corporate finance side of the markets for debt. In fact, in the U.S. - the economy that led the de-risking and deleveraging efforts during the early stages of the recovery - household debt is now once again reaching danger levels.

Chart 1 below shows that, based on data from NY Federal Reserve through 3Q 2016, full year 2016 average household debt levels are likely to exceed 2005-2007 average by some 3 percent. In 3Q 2016, total average household debt was around USD98,312, a level comparable to USD98,906 in 2006.

And Chart 2 shows that overall, aggregate levels of household debt and per capita levels of household debt both are now in excess of 2005-2007 averages.

Finally, as Chart 3 below indicates, delinquencies rates are also rising, despite historically low interest rates and booming jobs markets. For Student Loans and Car Loans, 3Q 2016 delinquencies rates are 1 percentage points and 3.8 percentage points above the 2005-2007 average delinquency rates. For Mortgages, current delinquency rates are running pretty much at the 2005-2007 average. Only for Credit Cards do delinquency rates at the present trail behind the 2005-2007 average, by some 2 percentage points.

Now, consider the market expectations of 0.75-1 percentage increase in Fed rates in 2017 compared to 3Q 2016 (we are already 0.25 percentage points on the way with the most recent Fed decision). Based on the data from NY Fed, and assuming average 2015-2016 growth rates in credit forward, this will translate into extra household payments on debt servicing of around USD1,085-USD1,465 per annum depending on the passthrough rates from policy rate set by the Fed and the retail rates charged by the banks.

Given the state of the U.S. household finances, this will be some tough burden to shoulder.

So here you have it, folks:
1) Corporate debt bubble is at an all-time high
2) Government debt bubble is at an all-time high
3) Household debt bubble is at an all-time high.
Meanwhile, equity funding is slipping even for the usually credit-shy start ups.

And if you want another illustration, here is total global Government debt, based on IMF data:

We’ve learned no lessons from 2008.


Sources for data:
https://www.nerdwallet.com/blog/average-credit-card-debt-household/
https://www.newyorkfed.org/microeconomics/data.html
http://www.imf.org/external/pubs/ft/weo/2016/02/weodata/index.aspx

16/12/16: The Root of the 2007-2010 Crises is Back, with a Vengeance

There are several fundamental problem in the global economy, legacies of the past 20 years - from the mid 1990s on - that continue to drive the trend toward secular stagnations (see explainer here: http://trueeconomics.blogspot.com/2015/07/7615-secular-stagnation-double-threat.html).

One key structural problem is that of excessive reliance on credit (or debt) to drive growth. We have seen the devastating effects of the rapidly rising unsustainable levels of the real economic debt (debt that combines government obligations, non-financial corporate debt and household debt) in the case of 2008 crises.

And we were supposed to have learned the lesson. Supposed to have, because the entire conversation about structural reforms in banking and capital markets worldwide was framed in the context of deleveraging (reduction of debt levels). This has been the leitmotif of structural policies reforms in Europe, the U.S., in Australia and in China, and elsewhere, including at the level of the EU and the IMF. Supposed to have, because we did not that lesson. Instead of deleveraging, we got re-leveraging of economies - companies, households and governments.

Problem Case Study: U.S. Corporates

Take the U.S. corporate bonds market (that excludes direct loans through private lenders and intermediated loans through banks) - an USD8 trillion-sized elephant. Based on the latest research of the U.S. Treasury Department, non-banking institutions - plain vanilla investment funds, pension funds, mom-and-pop insurance companies, etc are now holding a full 1/4 of U.S. corporates bonds. According to the U.S. Treasury, these expanding holdings of / risk exposures to corporate debt are now "a top threat to stability" of the U.S. financial system. And the warning comes at the time when U.S. corporate debt is at an all-time high as a share of GDP, based on the figures from the Office of Financial Research.

And it gets worse. Since 2007, corporate debt pile in the U.S. rose some 75 percent to USD8.4 trillion, based on data from the Securities Industry and Financial Markets Association - which is more than USD8 trillion estimated by the Treasury. These are long-term debt instruments. Short term debt obligations - money market instruments - add another USD 2.9 trillion and factoring in the rise of the value of the dollar since the Fed meeting this week, closer to USD3 trillion. So the total U.S. corporate debt pile currently stands at around USD 11.3 trillion to USD 11.4 trillion.

Take two:

1. Debt, after the epic deleveraging of the 2008 crisis, is now at an all-time high; and
2. Debt held by systemic retail investment institutions (insurance companies, pensions funds, retail investment funds) is at all time high.

And the risks in this market are rising. Since the election of Donald Trump, global debt markets lost some USD2.3 trillion worth of value. This reaction was driven by the expectation that his economic policies, especially his promise of a large scale infrastructure investment stimulus, will trigger inflationary pressures in the U.S. economy that is already running at full growth capacity (see here: http://trueeconomics.blogspot.com/2016/12/151216-us-economic-policies-in-era-of.html). Further monetary policy tightening in the U.S. - as signalled by the Fed this week (see here: http://trueeconomics.blogspot.com/2016/12/151216-long-term-fed-path-may-force-ecb.html) will take these valuations down even further.

Some estimates (see https://www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market) suggest that the Republican party corporate tax reforms (that might remove interest rate tax deductibility for companies) can trigger a 30 percent drop in investment grade bonds valuations in the U.S. - bonds amounting to just under USD 4.9 trillion. The impact would be even more pronounced on other bonds values. Even making the estimate less dramatic and expecting a 25 percent drop across the entire debt market would wipe out some USD 2.85 trillion off the balancesheets of the bonds-holding investors.

As yields rise, and bond prices drop, the aforementioned systemic retail investment institutions will be nursing massive losses on their investment books. If the rush to sell their bond holdings, they will crash the entire market, triggering potentially a worse financial meltdown than the one witnessed in 2008. If they sit on their holdings, they will be pressed to raise capital and their redemptions will be stressed. It's either a rock or a hard place.


Problem Extrapolation: the World

The glut of U.S. corporate debt, however, is just the tip of an iceberg.

As noted in this IMF paper, published on December 15th, corporate leverage (debt) has been on a steady march upward in the emerging markets (http://www.imf.org/external/pubs/ft/wp/2016/wp16243.pdf).

And in its Fiscal Monitor for October 2016, the Fund notes that "At 225 percent of world GDP, the global debt of the nonfinancial sector—comprising the general government, households, and nonfinancial firms—is currently at an all-time high. Two-thirds, amounting to about $100 trillion, consists of liabilities of the private sector which, as documented in an extensive literature, can carry great risks when they reach excessive levels." (see http://www.imf.org/external/pubs/ft/fm/2016/02/pdf/fm1602.pdf)

Yes, global real economic debt now stands at around USD152 trillion or 225 percent of world GDP.

Excluding China and the U.S. global debt levels as percentage of GDP are close to 2009 all time peak. Much of the post-Crisis re-leveraging took place on Government's balancehseets, as illustrated below, but the most ominous side of the debt growth equation is that private sector world-wide did not sustain any deleveraging between 2008 and 2015. In fact, Advanced Economies Government debt take up fully replaced private sector debt growth rates contraction. Worse happened in the Emerging Markets:

So all the fabled deleveraging in the economies in the wake of the Global Financial Crisis has been banks-balancesheets deleveraging - Western banks dumping liabilities to be picked up by someone else (vulture funds, investors, other banks, the aforementioned systemic retail investment institutions, etc).

And as IMF analysis shows, only 12 advanced economies have posted declines in total non-financial private debt (real economic debt) as a share of GDP over 2008-2015 period.  Alas, in the majority of these, gains in private deleveraging have been more than fully offset by deterioration in government debt:

Crucially, especially for those still believing the austerity-by-cuts narrative presented in popular media, fiscal uplift in debt levels in the Advanced Economies did not take place due to banks-rescues alone. Primary fiscal deficits did most of the debt lifting:

In simple terms, across the advanced economies, there was no spending austerity. There was tax austerity. And on the effectiveness of the latter compared to the former you can read this note: http://trueeconomics.blogspot.com/2016/12/10122016-austerity-three-wrongs-meet.html. Spoiler alert: tax-based austerity is a worse disaster than spending-based austerity.

In summary, thus, years of monetarist activism spurring a massive rise in corporate debt, coupled with the utter inability of the states to cut back on public spending and the depth of the Global Financial Crisis and the Great Recession have combined to propel global debt levels past the pre-crisis peak to a new historical high.

The core root of the 2007-2010 crises is back. With a vengeance.

20/7/16: McKinsey's "Generation Worse"...

A new study from McKinsey looks at the cross-generational distribution of income as a form of new ‘inequality’, in words of the authors: “an aspect of inequality that has received relatively little attention, perhaps because prior to the 2008 financial crisis less than 2 percent of households in advanced economies were worse off than similar households in previous years. That has now changed: two-thirds of households in the United States and Western Europe were in segments of the income distribution whose real market incomes in 2014 were flat or had fallen compared with 2005.”

In other words, McKinsey folks are looking at the “proportion of households in advanced economies with flat or falling incomes” - the generational cohorts that are no better than their predecessors.

Key findings are frightening: “Between 65 and 70 percent of households in 25 advanced economies, the equivalent of 540 million to 580 million people, were in segments of the income distribution whose real market incomes—their wages and income from capital—were flat or had fallen in 2014 compared with 2005. This compared with less than 2 percent, or fewer than ten million people, who experienced this phenomenon between 1993 and 2005.”

So that promise of the ‘sharing economy’ and the ‘gig-economy’ where people today are enabled to derive income (and thus wealth) from hereto under-utilised ‘assets’… pwah! not doing much. The ‘most empowered’ - web and gig-economy wise cohorts? Ah, they are actually the “worst-hit” ones. “Today’s younger generation is at risk of ending up poorer than their parents. Most population segments experienced flat or falling incomes in the 2002–12 decade but young, less-educated workers were hardest hit”.

For those of us who, like myself, tend to be libertarian in our view of the Government, McKinsey study tests some of our accepted ‘wisdoms’: “Government policy and labor-market practices helped determine the extent of flat or falling incomes. In Sweden, for example, where the government intervened to preserve jobs, market incomes fell or were flat for only 20 percent, while disposable income advanced for almost everyone. In the United States, government taxes and transfers turned a decline in market incomes for 81 percent of income segments into an increase in disposable income for nearly all households.”

Except, may be it did not, because counting in disposable income while allowing for taxes and subsidies is notoriously difficult and imprecise. And may be, just may be, all the fiscal imbalances that were accumulated in the process of achieving these supports in some (many) countries will still have to be paid by someone some day?

There is a reduced connection between current growth metrics and income outcomes on the ground (don’t we know as much here in Ireland, with 26.3% jump in GDP in 2015?): “Before the recession, GDP growth contributed about 18 percentage points to median household income growth, on average, in the United States and Europe. In the seven years after the recession, that contribution fell to four percentage points, and even these gains were eroded by labor market and demographic shifts.”

And the forward outlook? Bleak: “Longer-run demographic and labor trends will continue to weigh on income advancement. Even if economies resume their historical high-growth trajectory, we project that 30 to 40 percent of income segments may not experience market income gains in the next decade if labor-market shifts such as workplace automation accelerate. If the slow growth conditions of 2005–12 persist, as much as 70 to 80 percent of income segments in advanced economies may experience flat or falling market incomes to 2025.”

There are some wrinkles in the study. For example, in the U.S. case - cross time comparatives do not provide for the same data base, as pre-2014 data does not include state and local taxes. VAT and sales taxes are omitted across the board. And some other, but overall, the paper is pretty solid and very interesting.

So here is the key summary chart, positing the massive jump in the numbers of households on the declining side of market incomes:

And the chart showing that the taxes and transfers side of income supports is no longer sustainable over time:

Which brings us to the main problem: on the current trend line, politics of income supports from the fiscal policy side are unlikely to be able to contain growth in political discontent. Advanced economies are heading for serious tests of democratic institutions in years to come. Buckle your seat belts: the ride is going to get much rougher.

10/5/16: Debt, Government Debt, Glorious Debt

It's a simple headline, really, for a single chart:

But it says so much... peace time and monetary financing and printing presses and private sector QEs and on and on... as the 'economic recovery measures' roll out, the old staple of Government debt is going up. Austerity or none, growth is weak. Yet, Governments are borrowing at rates that are simply beyond control.

In simple terms: we have deteriorating fundamentals (interest rates at nil or negative, but growth nowhere to be seen) and we have continuously mispriced risk. If this ain't a bubble, what is?..

11/1/16: Dealing with Systemic Sovereign Debt Crises: IMF's Animal Farm Model

IMF brainiacs have been struggling over time to develop some sort of a coherent framework for managing the fallouts from systemic sovereign debt crises. So far, the golden rule has ben elusive for them. However, following the Cypriot and Greek experiences with private sector bail-ins and realising the direct connection between these experiences and the cases of other peripheral Euro area states, most notably Ireland and Portugal, the IMF have been coming around to the idea that while all countries are ‘equal’, some are ‘more equal’ than others. In other words, that in the world where might is right, there are two tiers of countries: those that get whacked and those that get properly rescued.

Behold the IMF’s latest thinking on the subject. Sandri, Damiano of IMF’s research department authored a new working paper, titled “Dealing with Systemic Sovereign Debt Crises: Fiscal Consolidation, Bail-Ins or Official Transfers?” (October 2015, IMF Working Paper No. 15/223: http://ssrn.com/abstract=2711133).

It says what it does: “The paper presents a …model to understand how international financial institutions (IFIs) [read IMF and European ESM/EFSM/EFSF and so on] should deal with the sovereign debt crisis of a systemic country, in which case private creditors' bail-ins entail international spillovers.” Notice the emphasis on ‘systemic’ country. In other words, ‘not the ordinary fry’ like smaller ‘peripherals’.

“Besides lending to the country up to its borrowing capacity, IFIs face the difficult issue of how to address the remaining financing needs with a combination of fiscal consolidation, bail-ins and possibly official transfers. To maximize social welfare, IFIs should differentiate the policy mix depending on the strength of spillovers. In particular, stronger spillovers call for smaller bail-ins and greater fiscal consolidation.” Which simply says: more systemic is a country, less risk of bail-ins, so if you are a French or a German depositor or lender, you are lucky. If you are a Belgian or Irish depositor or lender, tough sh*t, mate.

“Furthermore, to avoid requiring excessive fiscal consolidation, IFIs should provide highly systemic countries with official transfers. To limit the moral hazard consequences of transfers, it is important that IFIs operate under a predetermined crisis resolution framework that ensures commitment.” Oh, what this means is that systemic countries get bailed out via official sector (IMF et al) burden sharing. Small countries - get screwed by not having access to such largess.

Here’s more beef from the paper:

“…consider the optimal policy mix to address the financing needs of a non-systemic country, for which bail-ins do not entail international spillovers. In this case, besides lending to the country up to its borrowing capacity, IFIs should use only fiscal consolidation and bail-ins.” In other words: small country gets only funds sufficient to cover its standing allowance under the normal rules and not a penny more. Rest of ‘rescue’ funds should be squeezed out of the country economy. “Official transfers should …be avoided because they do generate severe moral hazard since they are not priced into countries’ ex-ante borrowing rates.” Which simply says: look, bailing out through official burden sharing will not increase fiscal pain for smaller countries as yields on government debt are not going to rise high enough.

So, please, whack these small countries harder, to teach them a lesson and who cares about their economies and people. Lessons matter, you peasants.

Now onto systemic countries case: “Dealing with the sovereign debt crisis of a systemic country, …a first implication is that bail-ins should be used to a lesser extent since they are more socially harmful due to the associated spillovers. If IFIs are prevented from providing transfers, any reduction in bail-ins would need to be offset entirely through an increase in fiscal consolidation. In this case, systemic countries might be required to endure an excessive amount of consolidation to spare the international community from the systemic consequences of bail-ins. When dealing with systemic countries, it may thus become efficient to compensate the reduction in bail-ins not only through greater fiscal consolidation, but also with official transfers.” So in simple terms: if you are a big country, you will be treated entirely differently from a small country. Never mind that moral hazard thingy - systemic countries get official sector burden sharing, lending over allowed capacity and less bail-ins pressure.

Of course, the IMF Working Paper is not reflective of the Fund official position, as disclaimers go. So this paper is nothing more than a ‘discussion’ of what should take place, rather than what will take place. But, of course, we all know one simple fact: in the world of IMF, some countries are ‘more equal’ than others.

29/12/15: There Are Two Ways 2016 Can Play Out for Euro Area Bonds

With the pause in ECB QE over the holidays season, bond markets have been largely looking forward to 2016 and counting the blessings of the year past. The blessings are pretty impressive: ECB’s purchases of government bonds have driven prices up and yields down so much so that at the end of this month, yields on some USD1.68 trillion worth of Government bonds across 10 euro area countries have been pushed below zero.

Per Bloomberg chart:

Value of bonds with yields below ECB’s -0.3% deposit rate, which makes them ineligible for purchases by the ECB, is $616 billion, just shy of 10 percent of the $6.35 trillion of bonds covered by the Bloomberg Eurozone Sovereign Bond Index. As the share of the total pool of marketable European bonds, negative yield bonds amounted to more than 40% of the total across Europe at the start of December (see here: http://www.marketwatch.com/story/40-of-european-government-bonds-sport-negative-yields-and-more-may-follow-2015-12-02).

Two questions weigh on the bond markets right now:
1) Will the ECB expand the current programme? Market consensus is that it will and that the programme will run well beyond 1Q 2016 and spread to a broader range of securities; and
2) Will low inflation environment remain supportive of monetary easing? Market consensus is that it will and that inflation is unlikely to rise much above 1% in 2016.

In my view, both consensus positions are highly risky. On ECB expectations. Setting aside inflationary dynamics, ECB has continuously failed to ‘surprise’ the markets on the dovish side. Nonetheless, the markets continued to price in such a surprise throughout 2015. In other words, current pricing is probably already reflecting high probability of the QE extension/amplification. There is not much room between priced-in expectations and what ECB might/can do forward.

Beyond that, my sense is that ECB is growing weary of the QE. The hope - at the end of 2014 - was that QE will give sovereigns a chance to reform their finances and that the economies will boom on foot of cheaper funding costs. Neither has happened and, if anything, public finances are remaining weak across the Euro area. The ECB has been getting a signal: QE ≠ support for reforms. And this is bound to weigh heavily on Frankfurt.

On inflationary side, when we strip out energy prices, inflation was running at around 1.0% in November and 1.2% in October. On Services side, inflation is at 1.2% and on Food, alcohol & tobacco it is at 1.5%. This is hardly consistent with expectations for further aggressive QE deployment and were ECB to engage in more stimulus, any reversion of energy prices toward the mean will trigger much sharper tightening cycle on monetary side.

The dangers of such tightening are material. Per Bloomberg estimate, a 1% rise in the U.S. Fed rates spells estimated USD3 trillion wipe-out from the about USD45 trillion valuation in investment-grade bonds issued in major currencies, including government, corporate, mortgage and other asset-backed securities tracked by BAML index:

Source here.

European bonds are more sensitive to the ECB rate hikes than the global bonds are to the Fed hike, primarily because they are already trading at much lower yields.

Overall, thus, there is a serious risk build up in the Euro area bond markets. And this risk can go only two ways in 2016: up (and toward a much worse blowout in the future) or down (and into a serious pain in 2016). There, really, is no third way…

22/7/15: Paging from the Planet Debt...

Ah, good old Europe... Austerity, Reforms, Structural Changes, Improved Competitiveness, Return to Growth... and rising, rising, rising debt.

Per latest Eurostat release (see here), euro area Government debt/GDP levels have hit 92.9% of GDP in 1Q 2015, up on 92.0% in 4Q 2014 and up on 91.9% of GDP in 1Q 2014. Year on year, Government debt rose from EUR9.179 trillion to EUR9.433 trillion.

Of the five most indebted (fiscally_ economies (excluding Ireland, which did not report 1Q 2015 GDP figures):

• Debt fell in the case of Greece by 8.3 percentage points between 4Q 2014 and 1Q 2015 to 168.8% of GDP; 
• Debt rose in the case of Italy by 3 percentage points to 135.1% of GDP;
• Debt fell 0.6 percentage points in Portugal to 129.6% of GDP;
• Debt rose 4.5 percentage points in Belgium to 111.0% of GDP;
• Debt fell 0.7 percentage points in Cyprus to 106.8% of GDP.

Italian debt is now at the highest level since the peak of Inter-war period in the 1920s:

Source: @Schuldensuehner 

Congratulations to the inhabitants of the Planet Debt...

17/2/15: Of Debt, Equity and the Wake Up Calls for the Financial Markets

My post for Learn Signal blog on the issues of debt v equity composition of the global financial markets: http://blog.learnsignal.com/?p=157

30/12/2014: Who Owns Government Debt?

An interesting chart via DB, mapping sovereign debt holdings across the advanced economies:

As the chart clearly shows, Irish Government debt is disproportionately held in the Central Bank. Other countries with similar proportion of CB-held debt - UK, US and Japan - all deployed direct QE. Ireland, of course, deployed virtually the same QE-like stimulus predominantly to the IBRC.

Another interesting feature is the share of Government debt held by foreign agencies: roughly 20% of the total, or 11th lowest in the sample of 21 countries. That is pretty low, given the amount of PR-talk the Government has been deploying around foreign buyers of Irish bonds.

In contrast, predictably, we rank the third after Greece and Portugal in the share of Government debt held by foreign official sector. This will decline once the IMF 'repayment' is finalised. Domestic banks' holdings of Irish debt are third lowest in the sample, and domestic non-banks holdings are 5th lowest. This is unlikely to change, given the sheer quantum of Government debt outstanding, relative to the overall economy's capacity and demand, and given the low yields on Government debt being generated.

The kicker of all of this is that owing to years of mismanaged bailouts, we are now saddled with the legacy of rescuing private debt holders in the banks. This legacy is simple: instead of private debt we have official debt, held predominantly by official sectors and our own CB, guaranteed by the Irish State. In other words, more of our debt is now super-senior in both rights and default terms.

26/12/2014: Advanced Economies: Public Debt Explosion 2008-2014

Some interesting insight into the legacy of the Great Recession that we are carrying over into 2015. From the start of 2008 through 2014:

• Average increase in gross debt of all advanced economies was 27.2 percentage points of GDP, with a range from a decrease of 21 percentage points for Norway and an increase of 88.5 percentage points for Ireland. Thus, the average annualised rate of increase in government debt over the period was around 3.47 percentage points of GDP with a range of -2.76 percentage points annualised decline for Norway and a 9.48 percentage points annualised increase in Ireland.
• Average change in the gross government debt of the group of countries where debt declined over the crisis was -12.0 percentage points of GDP. There were only 3 countries in this group.
• Average increase in gross government debt of the group of countries with benign levels of increase (levels of increase consistent roughly with offsetting GDP contraction over the crisis period) was 4.8 percentage points of GDP. There were only 5 countries in this group and only two of these were in Europe, with none (at the time of the crisis onset) being members of the euro area.
• Average increase in gross government debt within the group of countries where debt rises were moderately in excess of contraction in the economy was 16.4 percentage points of GDP.
• Average increase in gross government debt within the group of countries with debt increases significantly in excess of economic contraction was 26.6 percent of GDP.
• Average increase in the government debt within the group of countries with severe debt overhang was 60.4 percentage points of GDP, with a range of increases in this group between 41.6% for the U.S. at the lower end and 88.5% of GDP for Ireland at a higher end.

Chart above summarises these facts and also highlights the extent to which Ireland's government debt increases were out of line with experience in all other countries, including Greece and all other 'peripheral' economies.

The average rise in gross government debt across all peripheral economies 2008-2014 was 56.5 percentage points of GDP (excluding Ireland), which is more than 1/3 lower than that for Ireland. Our closest competitor to the dubious title of worst performing sovereign in terms of debt accumulation is Greece, which experienced a debt/GDP ratio increase almost 1/4 lower than Ireland.

And in case you wonder, our Government's net debt position is not much better:

20/12/2014: Remembering that Debt Pile on Our Shoulders

Three charts to illustrate the extent of Ireland's debt problem... that's right, the one that has not gone away with all the recovery talk.

Let's start in the happy days of 2007, when Irish Government's sustainable debt per capita was running at EUR10,775 and we ranked 11th most indebted nation (on per capita basis) in the today's EA18.

And fast-forward to 2014, when, based on the IMF projections, our Government debt per capita will amount to an eye-watering 'sustainable' EUR42,469 ranking us a run-away 1st in the debt load:

Needless to say, this record should have propelled us to the top of the league of EA18 nations in terms of debt increases during the crisis. And it did:

In Census 2011 (see here:  http://www.cso.ie/en/media/csoie/census/documents/census2011profile5/Profile,5,Households,and,Families,full,doc,sig,amended.pdf) the average household size in Ireland was 2.7 persons, implying that Government debt alone amounts today to EUR114,666, before the mortgage and other debts kick in. And when I say before, I mean it : the Government has priority over all other claims on income, including food and shelter.

So how do you feel now when you think of the Budget 2015 measure to ease the burden of DIRT on families saving for the downpayment on house purchase? Lavished by the warmth of a caring Government, undoubtedly...

22/7/2014: Remember that Fiscal Compact? Well, Don't Remind Europe...

Remember the Fiscal Compact? Yes, the one where debt/GDP ratio should be at 60% and the countries with ratios in excess of 60% must take 1/20th of the excess in adjustment down in debt per annum? So a country with 130% debt/GDP ratio is committed to an annual reduction of (130-60)/20=3.5% of GDP in year 1 and so on...

Oh, yes, the Fiscal Compact underpins the macroeconomic stability in the Euro area, making the euro as a currency 'sustainable'…

Oh yes, and the latest figures from the Eurostat on Government debt show that…

1. 18 out of EU28 countries have seen increases in Government debt/GDP ratios in Q1 2014 compared to Q1 2013.
2. 9 countries have posted increases in excess of 5% of GDP.
3. Year on year: the highest increases in the ratio were recorded in Cyprus (+24.6 pp), Slovenia (+23.9 pp), Greece (+13.5 pp) and Croatia (+9.9 pp), while the largest decreases were recorded in Poland (-7.7 pp), Germany (-3.2 pp), the Czech Republic (-2.2 pp), Latvia (-1.4 pp) and Belgium (-0.9 pp).
4. 15 EU28 countries had Government debt/GDP ratio in excess of 60%
5. EA18 Government debt in Q1 2013 stood at EUR8.793 trillion or 92.5% of GDP. In Q1 2014 this was EUR9.056 trillion or 93.9% of GDP. That is excluding intergovernmental debt. Adding this, Q1 2013 debt/GDP ratio was 94.6% and this rose to 96.3% in Q1 2014.

Good to see the Fiscal Compact holding so much better than the Maastricht Criteria.

So in the Age of European Austerity, savage cuts to public spending are resulting in rising debt at a rate of 1.7 percentage points of GDP per annum. One might wonder, were it not for the savage Austerity, where the debt levels might have been?

Full Eurostat release here: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22072014-AP/EN/2-22072014-AP-EN.PDF

10/1/2014: Top 5 Global Economic Risks of 2014: Sunday Times, January 5

This is an unedited version of my Sunday Times column for January 5, 2013.


2014 is the year of hope, arriving on foot of a renewed momentum in the economies of the U.S., U.K. and, since the beginning of the last quarter, the euro area. As welcome as these positive developments might be, any serious case for the economic fortunes revival in 2014 will have to stand against a rigorous analysis of risks and opportunities that are likely to emerge this year. Some are short-term; others are longer running themes signifying profound evolutionary transformations in the world of advanced economies.

Here are my top five picks for the economic risks and opportunities that are likely to mark 2014 the Year of Change.


1. Growth Challenge in Advanced Economies:

Core challenge faced by Ireland over 2014 and beyond is delivering sustainable rates of growth in excess of those recorded over the last decade.

Looking at growth in the GDP per capita reveals several worrisome trends.

Irish growth rates from 2005-through 2013 are running below the levels observed during 1980-1994. With a period of structural catching up with the euro area standard of living well behind us, the task ahead for Ireland is finding new sources for long-term growth.

The above challenges are compounded by the fact that our core trading partners are experiencing structural slowdown in their own economies. We are witnessing continued structural decline in the longer-term rates of growth in real GDP per capita across the advanced economies of the euro area that started in 1995. More immediately, the US and UK economies' recovery in the wake of the latest recession is slow, compared to the recessions experienced in the early 1990s and 1980s. Thus, Ireland is also facing the challenges of opening up new geographies, beyond our traditional trading partners in advanced economies, for exports and shifting more indigenous firms to exporting.

Currently, Irish medium-term growth outlook (2014-2018) implies growth rates that are some 3 times lower than those recorded in 1990s. A sustainable recovery from the crisis will require us delivering economic growth rates closer to those attained in the 1990s. Meanwhile, we are struggling to reach growth levels of the 1980s.

2. Medium-term Changes in Employment and Skills Demand

Significant reshaping of the advanced economies' labour force expected in 2012-2022 reflects the shifts in growth toward more human capital-intensive growth.

Increasing specialisation is changing Manufacturing and challenging both the U.S. companies operating in Ireland and Irish indigenous producers. In addition, the ICT Services sector is increasing demand for narrowly-defined specialist capabilities, leading to accelerating depreciation of the ICT sector skills and potential for reduction in overall levels of employment in the sector. The resulting contraction in demand for older skills will be magnified by the widening gap between in-demand new workers and legacy ICT employees.

The downsizing of the state sector will continue. The first wave of reductions during the Great Recession was driven by organic attrition, implying little improvement in productivity amidst staff losses. In the December Gallup poll, 72 percent of U.S. respondents identified 'Big Government' as the biggest threat to the country future, up from 52 percent in 2009. In Ireland, per Edelman Trust Barometer, trust in Government has remained at 15 percent in 2012-2013, ranking the Government alongside the banks as the least trusted institutions. The next wave will see a push for improved productivity, resulting in gradual reduction in employment levels in the sector and simultaneous shift in demand toward higher-skilled public sector workers.

On the other hand, Ireland is likely to gain from the Leisure and Hospitality, and Healthcare sectors growth on foot of ageing population across the major economies. The latter presents both a challenge and a major opportunity. Capturing global demand growth for Healthcare and Social Assistance services will require greater deployment of e-Health, remote health and other data-intensive, ICT-reliant healthcare tools. We are also likely to gain from renewed capital investment in the wake of strengthening global economic recovery. Financial services (chiefly IFSC), and Professional and Business services (especially innovation-focused internationally traded services), will gear up for rising demand. Education will remain a core driver for skills development and human capital investment.

3. Governments' Leverage Up, Banks Leverage Down

With its banking sector deleveraging largely completed, the U.S. economy is enjoying a credit-driven recovery. Both, the U.S. banks and the Federal Government are also increasing their access to global funding markets.

In contrast to the U.S., euro area banks are continuing deleveraging, while financial fragmentation is pushing national banks into greater isolation. With credit on decline for nineteen consecutive months, euro area economies remain starved of working and investment capital and capital markets integration is rapidly collapsing.

All along, buildup in public debt continues unabated without delivering a meaningful uplift in domestic investment activities. While in the U.S. public debt increases are supporting public investment and private consumption, euro area government leveraging up is primarily funding unemployment supports, public pensions and banks, with share of investment spending in total Government expenditure declining. As the result, euro area gross investment as percentage of GDP has declined from 21 percent over 2000-2002 to less than 18 percent in 2013. In the advanced economies ex-euro area gross investment slightly rose from just under 24 percent of GDP in 2000-2002 to 24.2 percent in 2013.

These trends act to reduce Irish exports of capital goods and investment-related services and undercut availability of credit in the domestic economy. The risk for 2014 is that the forces of financial fragmentation will remain at play across the euro area. The opportunity is the market readiness for entry of new investment and lending intermediaries.

4. Irish Labour Income Trends

Between 2008 and 2013, labour income share of Irish GDP has declined from 48 percent to 41 percent, implying a loss of roughly EUR3.3 billion in the domestic economy. This decline was driven primarily by re-orientation of GDP growth away from labour-intensive domestic sectors to MNCs-led exports of ICT and financial services.

As the result, declines in labour income have outpaced declines in value added in the economy, implying a transfer of income from the employees to the corporate and state sectors.

Taxes increases have compounded this effect, leading to a significant decline in household investment and consumption.

Over 2014-2016, Ireland faces a major challenge in rebuilding household financial positions and income to achieve sustainable levels of household debt, private investment and consumption. This can only be delivered by reducing the burden of taxation faced by the households, which puts us straight on the collision path between our corporate and wealth taxation policies, and the income tax policies reforms needed to restart the domestic economy.

Good news: by taking radical approach to rebalancing our tax system, we can do both – deliver sustainability-focused reforms and reboot the domestic economy. Bad news: our political and economic elites are too reliant on the status quo to secure their power to be able to structure and implement such reforms.

5. Monetary Policy Unraveling

2014 will mark the beginning of the end to unorthodox monetary policies deployed during the crisis.

This month, the U.S. Fed will begin gradual tapering of its purchases of the Government bonds. In advance of this, futures on 3 months Treasuries have been losing value since November. Meanwhile, euribor - the interest rate charged by top euro area banks for loans to each other - has been moving up relative to the ECB policy rate.

The ECB rates have now been in divergence from their historical mean for record 60 months. For now, Frankfurt is concerned with deflationary risks in the economy. Short-term eurodollar 3 month forward curve is pricing in euro devaluation in the short term and higher yields in the U.S. However, the return to historical norms for the ECB is only a matter of time. This will see rates rising over time toward the pre-crisis average of 3 percent from the current 0.25 percent.

For Ireland, normalisation of monetary policies presents significant risks. Rising interest rates, especially if compounded by the banks' drive to increase their lending margins, can derail nascent recovery, depress investment and destabilise once again the residential mortgages, including many that are deemed to have been ‘sustainably restructured’ prior to interest rates rises. In addition, higher yields on Government bonds will take a huge toll on Exchequer finances.

Unless this re-pricing in the bonds markets comes at the time of high growth in the Irish economy, the process of unwinding of global accommodative monetary policies can put us through a severe test, possibly as early as late 2014.

26/12/2013: Strategy for Growth 2014-2020 - A Fruitcake of Policy?

This is an unedited version of my Sunday Times column from December 22, 2013.


It is a well-known fact that virtually all New Year’s resolutions are based on the commitments adopted and promptly abandoned in the years past. Our Government’s reforms wish lists are no exception. Like an out-of-shape beer guzzler struggling to get out of the pub, our State longs to get fit year after year. Most of the time, nothing comes of it: bombastic reforms announced or committed to quietly slip into oblivion. Smaller parts of resolutions take hold; bigger items get buried in working groups and advisory panels. Thus, over the last decade, we have seen promises of reforms across the domestic sectors, protected professions, pensions and health systems, quangos, social welfare, government funding, tax systems, and so on. Virtually none have been delivered so far.

This week’s Strategy for Growth: 2014-2020 is the latest in the series of Governments’ ‘New Year, New Me’ resolutions. It is a lengthy list of things that have already been promised before. With a sprinkling of fresh thinking added. All of it is based on a strange mixture of pragmatism in fiscal targets, resting on economic forecasts infused with an unfunded but modest optimism. Giddy exuberance in confidence concludes the arrangement: confidence that the reforms which proved un-surmountable under the Troika gaze will be feasible in over the next seven years. The entire exercise promises a lot of reforms, but delivers little when it comes to realistic costings and risk assessments of the promises made.

In brief, the new Strategy is a disappointingly old fruitcake: pretty on the outside, inedible on the inside and full of stale trimmings, held together by the boisterous dose of potent optimism.


On Monday, the National Competitiveness Council unveiled its own version of a roadmap to the proverbial growth curve. The 32-page document on the New Economy contained no less than 65 references to the building and construction sector and 39 instances of references to property sector. No other sector of the economy was accorded such attention.

In the footsteps of NCC, on Tuesday, the Government launched its own multi-annual post-Troika policies roadmap.

The core point of the glossy tome is that Ireland needs a combination of policies to get its economy moving again. No one could have suspected such a radical thought. Majority of the policies listed are of ‘do more of the same’ variety. Some are novel, and a handful would have been even daring, were it not for the nagging suspicion that they represent political non-starters.


The plan has three pillars. Pillar one: fiscal discipline to keep Government debt under control. Pillar two: repairing the credit supply system and the banks. Pillar three: create an economy based on innovation, productivity and exports, and… building and construction. If you find any of this new, you are probably a visitor from Mars.

The document fails to provide any risk analysis in relation to all three pillars. Instead, it fires off pretty specific and hard-set targets and forecasts. Normally, the forecasts reflect the impact of policies being produced. In the Strategy 2014-2020 normality is an inverted concept, so forecasts enable targets that justify proposals.

There are two scenarios considered: the baseline scenario (better described as boisterously optimistic) and the high growth scenario (best described as wildly optimistic). None are backed by an analysis of sources of growth projections. No adverse scenario mentioned.

For the purpose of comparison, based on IMF model, Irish GDP, adjusting for inflation is forecast to expand by less than 12.3 percent between the end of 2013 and the end of 2018. In contrast, Government latest plan projects GDP to grow by over 16.1 percent in the case of high growth scenario. Nominal GDP differences between the high-growth and baseline scenarios amount to just 0.1 percentage points on average per annum. In other words, the distance between boisterous and wild optimism in Government’s outlook for the next seven years of economic growth is negligible.

By 2020 we will regain jobs lost during the crisis. But unemployment will be 8.1 percent under the baseline scenario and 5.9 percent under high-growth projections. Both targets are above the pre-crisis levels of around 4.7 percent. Which means that the Grand Strategy envisions jobs creation to lag behind labour force growth. The only way this can be achieved is by lowering employment to labour force ratio. This, in turn, would require increasing labour force more than increasing employment. In other words, the numbers stack up only if we simultaneously reduce emigration and push people off welfare benefits and into the jobs markets, and do so at the rates in excess of the new jobs creation. How this can be delivered is a mystery, although the Strategy promises more reforms to address these.

We will also transition to a fully balanced budget by 2018, eliminating the need to borrow new funds. Of course, we will still be issuing new debt to roll over old debt that will be maturing. Government debt itself will decline to below 100 percent of GDP by 2019. Per IMF latest estimates released this week, our General Government deficit in 2017-2018 will average around 1.5 percent of GDP and Government debt will end 2018 at around 112.2 percent of GDP. By Governments baseline scenario, we will be running a deficit of 0.25 percent of GDP on average over 2017-2018 and our debt will fall to 104 percent of GDP by the end of 2018. Optimism abounds.

To make these achievements feasible, let alone sustainable, will require drastic reforms far beyond what is detailed in the strategy documents. Instead of detailing these, Strategy for Growth: 2014-2020 leaves the major reforms open to future policy designs by various working groups.

For example, the Government Strategy talks high about the need to ensure sustainability of pensions provision. In an Orwelian language of the Strategy, having expropriated private pension funds before, the Government is now congratulating itself on achieving positive enhancements of the pensions system.

Yet, we all know that the key problems with current pensions system in Ireland are two-fold. One: we have massive under-supply of defined contribution pensions plans in the private sector. Two: we have massive deficits in defined benefit schemes that are predominantly concentrated in the public sectors. The Strategy documents published this week simply ignore the former problem. With respect to the latter one, the Government plan amounts to hoping that the problem will go away over time. Overall, going forward, the magic bullets in the State dealing with the vast pensions crisis are exactly the same as before: higher retirement age, gradual closing of defined benefit schemes and more studies into “setting out … long-term plans in this area”.

Another complex of Augean Stables of economic policies left untouched, potentially due to the influence of Labour is the tax system. Current income and social security taxes de facto penalise anyone considering an entrepreneurial venture. The Strategy puts forward no income tax reforms proposals. The document brags about the ‘progressivity’ of our income tax system and promises to retain this feature of the tax codes. Unions will be happy. Entrepreneurs, self-employed, higher-skilled workers, innovators, professionals, younger and highly educated employees, and exporting sectors workers will remain unhappy.

The Strategy admits that “Traditionally in Ireland starting and growing a business is considered less attractive by many than working in larger employers.” It goes on to stake a bold policy claim “to find innovative ways to encourage an entrepreneurial spirit.”

Stripped of fancy verbiage, the ‘innovative ways’ amount to a call to educate us all, toddlers and pensioners alike, about the goodness of entrepreneurship, and develop unspecified policies to make business failure more acceptable. Given the shambolic nature of the personal insolvency regime reforms designed by the current Government, there is little hope the latter objective can be met.

For intellectual gravitas, key marketing and PR words were deployed in the Strategy, promising more assistance, subsidies and supports to entrepreneurs, and more “clusters”. The same Strategy also promised to cut the number of business innovation assistance schemes and streamline business development programmes.

Taken together, these changes suggest that the Irish entrepreneurship environment will remain firmly gripped by State bureaucracy and will continue churning out state-favoured enterprises with clientilist business models. The fact that the said platform of enterprise supports, having been in existence for some 12 years, has failed to deliver rapid growth of innovation-focused high value-added indigenous entrepreneurship to-date seems not to bother our policymakers.

Other elephants in the room – some spotted by the very same Government years ago, while in opposition – are mentioned and, predictably, left unchallenged. One example: the Strategy promises yet another Action Plan to “identify ways to use Government procurement in a strategic way to stimulate … innovative solutions.” Back in 2011, this Government has already promised to do the same.

Overall, the fruitcakes of economic policy planning by the Government and NCC both lack vision and details. The two documents do contain some good, realistic and tangible ideas, but, sadly, these are buried beneath an avalanche of unspecified promises and uncontested figures. Risks to implementation of these policies may outweigh incentives for reforms. Lack of realism in expectations may overshadow the potential impact of the proposals.

More fruitcake, anyone? There’s loads left…

Box-out: 

In the latest report published this week, the European Banking Authority (EBA) analysed data from 64 banks with respect to their capital positions and the underlying Risk-Weighted Assets (RWA) holdings. Overall, capital position of the EU banking sector “continued to show a positive trend,” according to EBA, with Core Tier 1 capital holdings rising by EUR 80 billion. This, “combined with a reduction of more the EUR 800 billion of RWAs” means that the EU banks are building up risk buffers at the same time as pursuing continued deleveraging. The latter is the price for the former: higher capital ratios are good for banks’ ability to withstand shocks, deleveraging of assets is bad for credit supply to the real economy. On the net, however, as capital ratios rise, the system is being repaired so the price is worth paying. The improvements, however, were absent in one economy. Per EBA, Irish banks (Bank of Ireland, AIB and Permanent TSB) are unique in the EU in so far as they are experiencing simultaneous reduction in capital ratios and a decrease in Risk-Weighted Assets, which only partially offset the drop in capital. Put simply, Irish banks deleveraging is not fast enough to sustain current capital ratios: we are paying the price, but are not getting the benefits.

EBA chart (click to enlarge):

14/11/2013: With banks or without, things are heading for desperate in Italy...

The banks stress tests are coming up and the Euro periphery system is quickly attempting to patch up the massive cracks in the facade. The key one is the continued over-reliance of banks on sovereign-monetary-banking loop of cross-contagion. The banking system weakness is exemplified by Italy: Italian banks are the main buyers of Italian sovereign debt, which in turn means that Italian government stability rests on the banks ability to sustain purchasing, which implies that the ECB (with an interest of shoring up Italian economy) is tied into continuing to provide cheap funding necessary for the Italian banks to sustain purchasing of Italian Government debt… and so on.

Three key facts are clouding this 'stability in contagion' picture:

1. Banks in Italy and elsewhere are not deleveraging fast enough to allow them repay in full the LTROs coming due January and February 2015;
2. Banks in Italy are now fully saturated with italian Government debt, posing threats to future supply of Italian bonds and putting into question the robustness of the banking stress tests; and
3. Italian Government is running out of room to continue rolling over its massive debts.

If all 3 risks play out at the same time or close to each other, things will get testy for the Euro.


Point 1: Banks in the euro zone continue to carry assets that amount to three times the size of the euro area economy. This puts into question the core pillar of banking sector 'reforms' that the ECB needs to see before the banking union (BU) comes into being. The ECB needs to have clarity on quality of assets held by banks and, critically, needs to see robust deleveraging by the banks before th BU can be launched. If either one of these conditions is not fully met, the ECB will be taking over the banking system that is loaded with unknown and unpriced risks.

Per recent ECB data, Banks in the euro zone held EUR29.5 trillion in total assets by the end of 2012. That is down 12% on 2008. Too slow of a pace for a structural deleveraging. Worse, the bulk of the adjustments was back in 2009 and little was done since. Which makes the level of assets problem worse: on top of having too many assets, the system has virtually stopped the process of deleveraging. Knock on effect is that the firming of asset markets in Europe in recent two years was supported by a slowdown in assets disposals by the banks. In turn, this second order effect means that many banks assets on the books are superficially overvalued due to their withholding from the market. Nasty, pesky first and second order effects here.

Worse. Pressure on assets side is not limited to the 'periphery'. German banks held EUR7.6 trillion in total assets at the end of 2012, followed by the French banks with EUR6.8 trillion. Spain and Italy's banking sectors came in distant second and third, with EUR3.9 trillion and EUR2.9 trillion in total assets.

Capital ratios are up to the median Tier 1 ratio rising from 8% in 2008 to 12.7% in 2012. Quality of this capital is, however, subject to the above first and second order effects too - no one knows how much of the equity valuation uplift experienced by the euro area banks in recent months is due to banks reducing the pace of assets deleveraging…


Point 2: Assets quality in some large banking systems is too closely linked to the sovereign bonds markets. Italy is case in point. ECB tests are set to exclude sovereign debt risk exposures, explicitly continuing to price as risk-free sovereign bonds of the peripheral euro area states. But in return for this, the ECB might look into gradually forcing the banks to limit their holdings of sovereign bonds. This would be bad news for Italian banks and the Italian treasury.

The problem starts with a realisation that Italian banks are now primarily a vehicle for rolling over Government debt. Italy's Government debt is over EUR2 trillion. EUR397 billion of that is held by Italian banks. Another EUR200-250 billion can be safely assumed to be held by Italian banks customers who also have borrowings from these banks. Any pressure on the Italian sovereign and the ca EUR600 billion of Italian debt sloshing within the banking system of Italy is at risk.  That puts 20.7 percent of Italian banks assets at a risk play. [Note: by some estimates, Italian banks directly hold around 22% of the total Italian Government debt - close to the above figure of EUR397 billion, but way off compared to Spanish banks which are estimated to be holding 39% of the Spanish Government debt, hence all of the arguments raised in respect of Italy herein also apply to Spain. A mitigating issue for Spain is that it's debt levels are roughly half those of Italy. An exacerbating issue for Spain is that its deficit is second highest in Europe, well ahead of Italain deficit which is relatively benign).

Worse, pressure cooker is now full and been on a boiler for some time. In the wake of LTROs, Italy's banks loaded up on higher-yielding Italian Government debt funded by cheap LTRO funds - Italian banks took EUR255 billion in LTROs funds. In August 2013, Italian banks exposure to Italian Government debt hit EUR397 billion, just shy of the record EUR402 billion in June and double on 2011 levels. I

Either way, with or without explicit ECB pressure, Italian banks have run out of the road to keep purchasing Italian Government debt. Which presents a wee-bit of a problem: Italy needs to raise EUR65 billion in new debt in 2014. Italy is now in the grip of the worst recession since WWII and its debts are rising once again.

Chart below shows that:
1) Italian Sovereign exposures to external lenders declined in the wake of the LTROs, but are back to rising in recent quarters;
2) Italian banks reliance on foreign funding rose during the LTROs period, declined thereafter and is now again rising; while
3) Other (non-financial and non-state) sectors remain leveraged at the levels consistent with late 2006.

Point 3: Overall, Italian Treasury is now competing head on with the banks for foreign lenders cash and Italian corporate sector is being forced to borrow abroad in absence of domestic credit supply. Foreign investors bought almost 2/3rds of the last issue of Italian bonds, but how much of this appetite can be sustained into the future is an open question. Foreign investors currently hold slightly over a third of Italy's debt, or EUR690 billion, down from more than EUR800 billion back in 2011. The Italian Government is now turning to Italian households to mop up the rising supply. Italy issued EUR44 billion worth of inflation-linked BTP Italia bonds with 4 year maturity. As long as inflation stays low, the Government is in the money on these.

Next in line - desperate measures to raise revenues. Per recent reports, there is a proposal working its way through legislative corridors of power to raise tax on multinational on-line companies trading in Italy. The likes of Google, Amazon and Yahoo will be hit with a restriction on advertisers to transact only with on-line companies tax-resident in Italy, per bill tabled by the center-left Democratic Party (PD). The authors estimate EUR1 billion annual yield to the state - a tiny drop in the ocean of Italian government finances, but also a sign of desperation.

30/10/2013: Desperate? Just Check Out Italy's Latest Thoughts on Bonds...

Just when you think they (the Governments) have run out of creative ways to load risks onto taxpayers in order to boost sales of debt to fund own empires... here comes Italy with new twist on financial engineering in sovereign debt space: http://www.reuters.com/article/2013/10/21/italy-derivatives-guarantees-idUSI6N0HU01420131021

Desperate? You bet What will they think up next?..

H/T to @greentak

9/8/2013: PM Abe: a fella who makes history, quickly...

Roger, we have a problem... or rather - we now have a historic-level problem. Swept by Abenomics - the latest Japanese policy craze that believes in simultaneous borrowing and printing of excessive amounts of cash as a form of economic development, the Japanese economy is drowning in the sea of Government debt. This week, the Government has announced that its official debt levels have surpassed Yen 1,008,600 billion or Yen 1,008.6 trillion or Yen 1.0 quadrillion.

Never fear, this for now amounts to just USD10.42 trillion - a mere 230% of GDP. Abenomics has some room to run, yet... stay tuned and buckled up.

Source: http://www.zerohedge.com/node/477408 via @zerohedge

2/7/2013: Village June 2013: Real Effects of Government Debt Overhang?

This is an unedited version of my column in the Village Magazine, June 2013 edition.


Ever since the publication of the working paper by Thomas Herndon, Michael Ash and Robert Pollin (HAP) detailing their criticism of the 2010 paper by Carmen Reinhart and Kenneth Rogoff, Irish Left has been abuzz with the anti-austerian sloganeering.

According to the Left’s Neo-Keynesianistas, the article by Carmen Reinhart and Kenneth Rogoff, titled Growth in a Time of Debt and published in the American Economic Review in May 2010 (R&R, 2010) provided the intellectual foundation for the argument that austerity is necessary for countries with public debt in excess of or near the 90% of GDP bound.  And, according to the same Neo-Keynesiastas, the R&R 2010 article has now been demolished by the HAP critique.

In the immediate aftermath of the HAP publication, both the new and the traditional media channels were saturated with ‘the austerity is dead’ missives from angry Leftists of all shades. The HAP paper became the buzzword of the blogosphere, twitter and facebook, and its student co-author became an overnight celebrity.

Alas, the HAP critique of the Reinhart and Rogoff study grossly over-exaggerated the true extent the errors committed by Reinhart and Rogoff. The tidal wave of anti-austerity rhetoric unleashed since the HAP publication has vastly distorted the nature of the original study conclusions and ignored the large body of academic research on the relationship between public expenditure, economic growth and public debt.


Consider the HAP authors’ main charges against the R&R 2010 paper and the case of ‘austerity’ in general.

Firstly, the authors identified a glaring and undeniable error in the spreadsheet calculation relating to one of the six main reported findings contained in the R&R paper. This error, unfortunate as it might be, is neither influential in terms of the original results, nor significant in terms of disputing the core conclusions of the Reinhart and Rogoff body of research. Correcting for this error changes original estimates of the impact of debt on growth by just three tenths of a percent –within the statistical margins of error. In other words, economically, the error was barely significant. A 0.3% swing in growth for an ‘austerity-hit’ economy like, say Ireland or Spain, is indistinguishable from normal volatility in growth rates present in good and bad times alike. Over 1980-2012, standard deviation in real growth in the peripheral euro area states averaged more than nine times the magnitude of the excel error discovered by HAP.

Second, the authors have claimed that the methodology used in the R&R paper in computing three of the six core reported results was flawed. In fact, the major difference between HAP and Reinhart and Rogoff papers is found in the authors differing opinions as to which averages matter when it comes to summarizing countries’ experiences across periods of crises.

The significance of this error can be best understood in terms of a practical example, provided by James Hamilton of the University of California, San Diego.

Since 1945 through 2009 – the period covered by both papers – the US experienced debt to GDP ratio in excess of 90% over only 4 years. In contrast, Greece was in a similar predicament for 19 years. To compare the two countries experiences, one has to deal with the averages across time (4 years vs 19 years) and across countries (the US – with more structurally robust and much larger economy, against Greece – with weaker and smaller economy). Difference between periods matter: if the US experienced 4 years of high debt when the global economy was in slower growth period, some of the US slowdown is attributable to global conditions and had nothing to do with debt overhang. In contrast, if Greece experienced 19 years of debt overhang amidst, say, a robust global expansion, then more of the impact of excessive debt levels can be attributed to internal conditions in Greece. And so on: exchange rates, interest rates, and inflation regimes variations, and other differences between economies at different times – all matter.

HAP assume that the correct way to deal with all these differences is to ignore them completely. Thus, under HAP, the expected growth rate for Greece under debt overhang conditions (debt in excess of 90% of GDP) is exactly the same as it would be in the US. More than that, HAP assumptions also imply that growth rates volatility around the mean is identical in the US and Greece, despite the fact that smaller economies tend to be much more volatile than the larger ones, or that volatility in growth changes over time and across countries. The end result of the HAP assumption is that Greek experience of debt overhang is weighted as if it was almost five times more significant than the US experience.

In contrast, Reinhart and Rogoff assume that differences across economies and time do matter, and this means that we should consider separately the average growth rates in the US from those in Greece.

Table below shows a summary of the HAP results compared to Reinhart and Rogoff results.

Note that unlike Reinhart and Rogoff, HAP fails to report median values, which are (a) not as different from the HAP mean-based results as the R&R mean variables reported, and (b) were always clearly stated as the preferred results by Reinhart and Rogoff. The omission of the median findings reporting by HAP is a major one. The difference between the median and average growth rates reported in the original Reinhart and Rogoff paper is indeed very sizeable in the case of the countries reaching beyond the 90% debt/GDP threshold. This, statistically, indicates that there is a lot of skeweness in the data and suggests that in addition to being associated with lower growth rates, high debt/GDP ratios are also associated with greater risk or volatility in growth.


Despite all the hoopla about the HAP study, it confirms the main argument set out in the Reinhart and Rogoff paper, namely that breaching a 90% bound on Government debt to GDP ratio is associated with significantly slower rates of growth. This is something that the Neo-Keynesianistas are largely ignoring in their calls for scrapping the drive to structurally rebalance fiscal spending and revenue models operating in the countries with already high levels of Government debt. Uncomfortably for Neo-Keynesianistas, the analysis by Reinhart and Rogoff 2010 is broadly and even numerically close to other studies by the two authors which were based on different data and models, as well as to papers from BIS (Cecchetti, Mohanty and Zampolli paper from 2011), ECB (Checherita and Rother, 2010 paper), the IMF (the World Economic Outlook, 2012), and a number of other studies. All of these papers have clearly confirmed that higher debt levels in post-war advanced economies are associated with indisputably lower levels of economic growth.

The debate re-ignited by HAP criticism of Reinhart and Rogoff 2010 paper is emblematic of the problem of politicized thinking on both sides of the austerian-neo-Kenesian divide.  Whilst we do not know much about the causality between debt and growth overall, what we do know is that:
1) Higher debt is associated with lower growth,
2) Higher debt is associated with higher present and future interest rates, and
3) Higher interest rates are associated with higher cost of borrowing for Governments, households and companies alike
The latter points were established for a number of advanced economies and across the post-war epriod in a recent paper from Bank of Japan (Ichiue and Shimizu, 2013), in Vincent Reinhart and Brian Sack 2000 study,  Thomas Laubach 2009 work for the US, Greenlaw, Hamilton, Hooper and Mishkin 2013 paper, Ardagna, 2004, and Baldcacci and Kumar 2010 studies, to name just a few.

The US Congressional Budget Office – hardly a hot house for austerians – clearly shows that US net interest cost of debt financing relative to GDP can be expected to double over the next decade.  This will take net interest cost of funding the US Government debt from 2.2% of GDP in 1973-2012 period to 3.7% of GDP by 2023. By 2018-2020, US Defense and non-Defense discretionary expenditures will be running below those on net interest funding.

In the case of another heavily indebted economy, Ireland, latest IMF projections show that interest on our debt will rise from EUR3.3 billion in 2009 (2.04% of GDP) to EUR9.4 billion by 2018 (4.6% of GDP). Full 65% of all income tax increases since 2009, including those to be achieved from the forecast increases in economic activity in Ireland through 2018 will be consumed by the hikes in interest cost on Irish Government debt. While the IMF does not publish underlying interest rates and Government bond yields assumptions, given the dynamic of debt accumulation, it is relatively safe to assume that the IMF is expecting Irish Government bond yields to average around 4% for 10-year bonds over 2013-2018 horizon. This expectation can be rather optimistic. As I repeatedly pointed out in a number of presentations, we can expect ECB repo rate to rise to above 3.1% historical average in medium term future. With risk premium broadly consistent with higher Irish debt levels, this can lead to sovereign yields averaging closer to 5% over the 2013-2018 period. In this case, Government interest costs can run to EUR12 billion or closer to 5.75% of GDP. If this were to occur, growth in the economy projected by the IMF can fall short of the levels required to deflate our Government debt to GDP ratios.

If neo-Keynesianists think this to be sustainable, we can add the potential impact of higher government yields on cost of funding Irish mortgages and corporate loans.

Another major issue missing in the HAP v Reinhart & Rogoff debate is the question as to whether the aggregate comparatives based on datasets pooling together vastly distinct countries over different periods of time and underlying economic conditions is a meaningful way for looking at the debt overhang problems. In the case of Ireland, consider two sub-periods of high Government indebtedness: the 1980s and the present period. In both, debt/GDP ratios for the Irish Government were running at similar levels. However, the 1990s were associated with Ireland facing an exceptionally robust global demand for its exports. Ireland’s comparative advantage vis-a-vis our main trading partners – our high corporate tax rate incentives and low cost basis – drove rapid expansion of our exports. Low interest rates environment that followed devaluations of the currency has resulted in a series of asset bubbles helping to reduce debt/GDP burden inherited from the 1980s. None of these conditions are present in Ireland today. Lastly, whilst in the 1980s Irish debt levels were flashing red only for Government debt, today we have one of the most-indebted private and public sectors economies in the world.

Which means – in terms of the table above – that we are not starting from a 4%-plus growth benchmark of pre-crisis long term growth trend and we are not heading for a 1.6% median or 2.2% average growth rate in the aftermath of the debt overhang crisis. More likely than not, we are going from a structural growth rate of 2-2.5% pre-crisis to a post-crisis long-term average growth rate of 1%. Whatever Reinhart and Rogoff or HAP aggregates might tell us about the future, it is hardly going to be rosy unless we get our debt and deficits under control and, more crucially, unless we shift our economy from slower structural growth path associated with current economic environment here onto a higher growth path.

How this can be achieved, however, is an entirely different debate from the superficial austerians v neo-Keynesianists ‘to cut or not to cut’ ideological warfare.