30/4/2013: Irish chart that worries me most

The chart that bothers me most in Irish context is:

This shows the structural nature of the growth slowdown in Ireland in post-2007 period (based on IMF forecasts through 2018). The period of this slowdown is consistent with the growth rates recorded in the 1980s. And here's the summary of decade-average real GDP growth rates:

Now, keep in mind, in the 1980s and 1990s, Irish growth was driven by a combination of domestic drivers, plus external demand, primarily and predominantly in the goods exports areas. Which means that more of our GDP actually had real impact on the ground in Ireland. Since the onset of the crisis, most of our growth has been driven by the growth in exports of services, which have far less tangible impact on the ground.

Another point to make: current rates of growth for the 2010s are below those in the 1980s and, recall back, the rates of growth achieved in the 1980s were not enough to deflate the debt/GDP overhang we had. Of course, in addition to the Government debt overhang (similar to that in the 1980s) we also now have a household and corporate debt overhang.

If the IMF projections above turn out out be close to reality, we are in a structural decline economically and are unlikely to generate sufficient escape velocity to exit the debt crisis any time before 2025 at the earliest.

10/4/2013: EU Commission on debt-overhang in Europe

A new paper on the effects of debt and deleveraging in Europe was published by the EU Commission. The paper can be accessed here.

Some nice charts summarising the debt overhang in the real economy (households and non-financial corporates):

Gross level relative to GDP, Irish households are 3rd most indebted in the euro area by 2011 measure. However, adjusting for GDP/GNP gap puts us at the top position, well ahead of Cyprus and even ahead of the EU27 'leader' - Denmark.

Now, much is usually being said about Irish net debts being lower due to immense wealth accumulated by the households. Table above shows that, actually, that is not true. We rank second from the top. Interest burden has declined, but it remains the third highest in the euro area.

Now to non-financial corporations:

 Irish corporates are second most indebted (after Luxembourg) in the EU and adjusting for GDP/GNP gap, the difference to the third most-indebted country is even more dramatic than the chart above indicates. Irish corporates debt rose in 2008-2011, rather dramatically - marking the highest increase in the euro area.

Detailed decomposition:

Again, adjusting for GDP/GNP gap, Irish economy is the most indebted in the euro area and the EU when measured relative to overall economy size (note: Luxembourg comparatives are wholly meaningless due to massive presence of brass-plates operations in the economy).

More fun charts:

Again, Ireland is in top first (corporates ex-Luxembourg) or second (households) positions.

Deleveraging household debt overhang will be extremely painful for Ireland:

And although asset valuations suggest the pain will be milder, in reality, one has to consider the fact that Irish household assets valuations are not exactly (a) fully reflective of real extent of price contractions in the housing sector, and (b) liquid.

 Here's EU Commission view:
"as regards households capacity to repay (figure 12), Ireland, Spain, Estonia, the Netherlands, Latvia, Denmark, the United Kingdom and, to some extent, Cyprus are amongst those that experienced a rapid increase in household indebtedness before the crisis. Despite the varying starting position in terms of household debt, the information content of the level dimension also points to the same set of countries as potentially prone to suffer from deleveraging pressures, on top of Portugal and Sweden. Ireland, Latvia and Estonia also appear as subject to high  pressures when considering actual leverage as well as its build-up (figure 13)".

And on non-financial corporates deleveraging:
"on the firms' side, there is also a clear positive relationship between the  accumulation and the level factors when considering the capacity to repay (figure 14). Countries like Belgium, Ireland, Spain, Cyprus, Portugal and Bulgaria stand out as presenting vulnerabilities related to their firm's indebtedness. This snapshot is highly nuanced when looking at firm's asset side (see figure 15). Belgium and Cyprus present a healthier picture while firms in countries like Greece, Italy, Slovenia and Latvia appear as subject to higher pressures. As a robustness check, this exercise was also run with consolidated data and the results are consistent but for the case of Belgium, where the relevance of intra-company loans calls for further qualifications when assessing non-financial corporates debt sustainability"

Using more sophisticated analysis, the Commission paper concludes that:
"The following countries can be identified as more prone to face deleveraging pressures in the household and non-financial corporation sectors: Cyprus, Denmark, Spain, Ireland, the Netherlands, Portugal, Estonia, Latvia, Slovakia, Sweden and the United Kingdom on the household side and Belgium, Bulgaria, Cyprus, Greece, Spain, Hungary, Ireland,  Italy, Portugal, Estonia, Latvia, Slovenia, Sweden and the United Kingdom on the corporate side."

Of all countries listed above only Ireland, Cyprus, Spain, Portugal, Estonia, Latvia, Sweden and the UK fall into both groups, but only Ireland falls into extreme scenarios of debt sustainability in both categories:

In EU Commission calculations (see link above), Ireland has the greatest gap to sustainability (35.2%) when it comes to debt overhang in the entire euro area, and second highest in the EU.

4/4/2013: Real Debt: European Crisis in 4 charts

Some interesting charts from Liu, Yan and Rosenberg, Christoph B., World Economic Outlook, April 2013. IMF Working Paper No. 13/44. Available at SSRN: http://ssrn.com/abstract=2229653

Chart 1 below details the extent of the debt overhang in a number of countries:

Charts 2 and 3 outline the problem relative to financial assets available to offset the debt (theoretical offset, obviously):

Non-performing loans problem...

Quite telling, with no commentary needed, imo.

22/3/2013: Sunday Times, 17/03/2013

This is an unedited version of my Sunday Times article from March 17.


Economics is an art of contention. In so far as economics body of knowledge is concerned, the world is largely composed of an infinite number of things that are either uncertain, or open to interpretation. One of the very few near-certainties that economists do hold across the ideological and philosophical divisions is that an economy undergoing deleveraging of household debt is likely to experience a lengthy period of below-trend growth. The greater the debt pile to be deleveraged, the faster was the period of debt accumulation, the longer such a recession or stagnation will last.

Another near-certainty is that in a debt crisis, economy is unlikely to recover on foot of either monetary or fiscal stimuli. Monetary easing can help the deleveraging process if and only if low policy rates translate into cheaper mortgages on the ground. This requires a functioning banking system, in addition to monetary policy independence. Fiscal stimulus can only help to the extent to which it can temporarily stimulate growth, and even then the impact on more indebted households is unlikely to be any stronger than on less-indebted ones. Longer-term effects of a significant debt-financed fiscal stimulus in an economy already struggling with government and household debt, are more likely to be detrimental to the overall process of deleveraging. Higher debt today necessary to fund economic stimulus translates into higher burden of that debt in the future.

Meanwhile, deleveraging of the households in and by itself, even absent banking and other crises, is a process associated with dramatically reduced economic activity and growth.

Households struggling with a debt overhang are effectively removed from being active participants in the economy. Indebted households do not save, thus depleting their future pensions provisions and reducing overall levels of investment in the economy. Indebted households tend to cut back their consumption, both in terms of large-ticket durable goods and in terms of everyday items. They also reduce consumption of higher-quality higher-cost goods, adversely impacting domestic producers in higher-cost economies, like Ireland, favoring more competitively priced imports.

With banks beating on their doors, indebted households abstain from entrepreneurship and engage less actively in seeking improved employment opportunities. The latter means that indebted households, fearing even a short-term spell in unemployment, do not seek to better align their skills and talents, as well as future prospects for promotion with jobs offers. This, in turn, implies loss of productivity for the economy at large. The former means slower rate and more risk-averse entrepreneurship resulting in further reduction in future growth potential for the economy.

Last, but not least, household debt overhang results in increased rates of psychological and even psychiatric disorders, incidences of self-harm, suicide, stress and social dislocations. These effects have a direct and adverse impact on public services, the economy and the society at large.

In Irish context, the effects of household debt overhang (most acutely expressed in mortgages arrears) are likely to be significantly larger than in normal debt crises episodes and last longer.

Consider the sheer magnitude of the problem. In an average debt crisis, household debt arrears peak at around 7-10% of the total debt outstanding. Per latest data from the Central of Bank of Ireland, at the end of 2012, 143,851 private residential mortgages accounts and 37,995 buy-to-let accounts were in arrears. Total number of mortgages in arrears represented 19% of all mortgages outstanding.  Total balance of mortgages in arrears amounted to EUR35.4 billion, or 25% of the entire mortgages-related debt. Mortgages at risk of default or defaulted (defined as all currently in arrears, relating to properties with repossession orders and mortgages restructured during the crisis, but currently not in arrears) amounted to 238,663 accounts and EUR45.3 billion of the outstanding debt, or 25.3% and 31.9% of the respective totals.

Given expected losses from the above mortgages in the case of repossessions and/or insolvency, and inclusive of the interest costs due on this unproductive debt, over the next 3 years Irish economy is likely to face direct losses from this mortgages crisis to the tune of EUR20 billion. This will reduce our current level of gross fixed capital formation in the economy by 40 percent in every year through 2015.

In indirect costs, the crisis currently is impacting some 650,000-700,000 individuals living in the households with mortgages at risk, as well as countless others either in the negative equity or arrears on unsecured debt (credit cards, credit unions’ loans, utility bills etc).  Using basic cost of health insurance coverage, the relationship between health insurance spend in Ireland and cost of public healthcare, and assuming that annual cost of higher stress associated with debt overhang amount to just 10% of the total annual insurance costs, direct health costs alone from the debt crisis can add up to EUR400-500 million per annum. Factoring productivity losses due to stress, the total social, psychological and psychiatric costs of the mortgages arrears can run over a billion.

Costs of foregone entrepreneurship are even harder to quantify, but can be gauged from the overall decline in investment. In 2012 the shortfall in aggregate domestic investment activity compared to 1999-2003 annual average (taking the period before the rapid acceleration in property bubble) was running at ca EUR6.9-7.0 billion. This shortfall is roughly comparable to the above estimated annualized cost of servicing defaulting and at risk mortgages. Gross investment in Ireland is now running at a rate not seen since 1997.  Meanwhile, net expenditure by the local and central Government on current goods and services is running above 2005 levels, same as personal consumption of goods and services. This suggests that our current rates of domestic investment and associated entrepreneurship are down more significantly than personal and Government spending.

In some sectors, things are even worse.  Construction sector is clearly seeing no turnaround with new residential construction permits down 88% in 2012 on the peak, heading for historical low of estimated full-year 14,022 permits based on data through Q3 2012. Extending mortgage arrears crisis or deepening the households’ already significant debt overhang through the means of forcing them into repaying the unsustainable loans will only exacerbate the crisis in Irish construction sector and in all sectors of domestic economy.

In years to come, the mortgages crisis today is likely to cost Irish economy around 10% of our GNP.

And it is unlikely to ease significantly any time soon, since the above costs exclude the effects of likely acceleration in mortgages defaults in months and years to come due to the adverse policy and economic headwinds.

Firstly, ongoing fiscal consolidation is shifting more burden of paying for our State onto the shoulders of Irish households, including those subsumed by the debt crisis. This process is not going to end with Budget 2014.

Secondly, reform of the personal insolvency regime will add fuel to the fire by giving banks disproportional powers over the households in structuring long-term solutions to the mortgages distress. Changes to the Central Bank code of conduct for the banks in dealing with borrowers, along with the accelerated targets for restructuring non-performing mortgages announced this week are likely to push the banks to more aggressively deal with the borrowers. These factors will amplify the rate of mortgages arrears build up, driving more households into temporary relief measures. These measures will structured by the banks in absence of transparent and efficient consumer protection to suit banks’ objectives of extracting all resources out of households for as long as possible before forcing the households into bankruptcy in the end.

Finally, mortgages arrears will continue to rise on foot of weak economic growth and continued re-orientation of the Irish economy away from domestic activity toward MNCs. This headwind closes the loop from the household debt overhang to depressed domestic investment to higher unemployment and lower domestic growth to an even greater debt overhang.

In order to deal with the mortgages crisis, we need a prescriptive approach to long-term solutions based on principles of borrower protection, standardization and transparency.

All lenders operating in Ireland should be required to publish a full list of solutions offered to the distressed borrowers which complies with the minimum standards set out by the Central Bank and a borrowers’ protection watchdog, such as reformed and independent Mabs. The financial criteria and conditions that qualify borrowers for such solutions should be disclosed. The process of finalizing the details of solutions should involve borrowers supported by an adviser, fully resourced to deal with the lender and independent from the lender and the state.

Only by matching borrower and lender powers and resources in a transparent and strictly supervised manner can we achieve a resolution to this crisis. Until then, this economy will continue operating well below its potential rate of growth, condemning generations of Irish people to debt slavery. The status quo of the state granting ever increasing powers to the banks in dealing with mortgages arrears is not sustainable and is likely to lead to both economic misery, continued emigration, and in the long run to political and social discontent. Sixth year into the mortgages crisis of extremely acute nature, we can not afford another round of half-measures and fake solutions.

Box-out:

This week auction of Irish bonds put to some test the theory of yields divergence with the euro area periphery. Compared to Italian Government bonds auction carried out on the same day, Irish 10 year bonds were greeted by the markets with a cheer.  While supportive of the analysts’ consensus view that Ireland is decoupling from the peripheral states, such as Italy, Portugal and Spain, the results of the auction were at least in part driven by factors outside the Irish Government control. This was the first 10 year bond issuance for Ireland in 3 years and the issue came without much of the adverse newsflow surrounding the economy. Complete absence of 10 year bonds in the secondary market prior to the auction assured some of the demand. For Italy, this was the first auction following Fitch downgrade of the sovereign to Baa1 rating – fresh in the memory of the markets. Italian newsflow has also been disappointing recently with elections outcome unnerving the markets and with GDP figures (Italy has reported its 2012 full year growth almost a month ahead of Ireland, which is still to post results for Q4 2012).

Just how much of this week’s result for Ireland can be accounted for by the factors unrelated to the Government policies or real economic performance is impossible to determine. Nonetheless, Minister Noonan’s cheerful references to the auction as ‘extraordinary’ in nature sounds more like a political PR opportunism than of financial realism.

10/9/2012: Corporate debt iceberg

Another topic, much ignored by the Irish media and the Government and covered by the IMF in today's releases is the corporate debt.

The chart below shows the extent of debt overhang in Ireland:

Here's what IMF has to say on that (emphasis mine):
"Despite an overall decline in corporate debt, an increasing number of firms are facing difficulties covering interest payments on debt. Interest coverage ratios [ratio of earnings before interest and taxes (EBIT) to interest expenses] have declined, with the interest coverage for the median firm having decreased from 6.9 in 2002 to 0.8 in 2009, and with an increasing number of firms not generating sufficient income to cover interest payments on outstanding debt. ... Moreover, the interest coverage is markedly lower for SMEs, with a median of 0.8 compared to 1.9 for large firms. The decline in firm profitability associated with depressed demand is playing an important role in the reduction in interest coverage ratio. This suggests that financing constraints are particularly important among SMEs and in property-related sectors."

In other words, whatever supply of credit is doing, demand for credit is severely constrained by deterioration in firms' financial sustainability.

Although "Leverage for the median firm (which is a small firm) has fallen to 46 percent of equity, with the usage of bank debt showing a similar decline. The data also indicate that trade credit and other non-debt liabilities play an important role in the financing of SMEs, together with internal financing from retained earnings." Although leverage overall has dropped, debt affordability has fallen off the cliff:

Why? "The decline in firm profitability associated with depressed demand is playing an important role in the reduction in interest coverage ratio. This suggests that financing constraints are particularly important among SMEs and in property-related sectors."


So what can be done? Here's the list of IMF outlined options:


"Credit guarantees or subsidies on SME loans can in principle stimulate SME financing. ... Until recently, Ireland was one of the few OECD countries without some form of loan guarantee scheme. ...However, the international experience with SME lending schemes is mixed. ...Moreover, the historical experience shows that credit guarantee schemes can only be effective when there are competent, financially sound banks, with adequate staff to effectively screen and monitor SME loans. ...

Government support for SMEs will need to be complemented with progress in improving the operational capacity of banks to work out loans. The restructuring of SMEs on a case-by-case basis is resource intensive yet important to ensure that where a viable core business exists, that it has the possibility to invest and grow, and contribute to broader economic recovery.

Considering the number of SMEs, it would not be appropriate to rely principally on court-based bankruptcy procedures. Rather, banks will need to build their capacity to design and implement work outs though out-of-court workout processes. Drawing on international expertise may well be needed to help major banks build capacity in this area.

The government could also explore ways to facilitate the securitization of SME loans. However, liquidity premia currently demanded by market participants even on senior
tranches, plus the inability of the Irish government to offer substantial credit enhancements
on such securitizations given the low sovereign credit rating, imply that, at least for the
moment, the market for securitization of SME loans is limited."

So, in other words: NOTHING can be done on the scale required. We are boxed into the corner with SMEs debt overhang too. All state resources and economy's resources wasted on rescuing the banks bondholdres, folks. No powder left for the rest of the economy. Sit tight and pray for a miracle.



Aside: An interesting observation via the IMF concerning the links between the negative equity and property values and firms formation: "With depressed home prices it has become more difficult to finance a new firm using home equity, which has hampered job creation."

10/9/2012: Insane path of Irish 'wealth'

Another interesting chart from the IMF reports today:

Now, look at the red line - Net Wealth in Ireland, which has dropped to levels below those in Q1 2002, while housheolds' total taxes (VAT and Income taxes combined, excluding other) has ballooned from €17.96bn in 2002 to €23.54bn in 2011. So let's do a simple mental exercise: net wealth is down ca 30%, household taxes are up ca 31%... and we are supposed to:

• Deleverage our own debt
• Deleverage the banks-related debts of the Exchequer

What a better illustration of madness can one find? Oh, wait, I know - the Armchair Socialists' one: "Ireland is a very wealthy country and we must tax wealth to extract funds for the Government". Alas, we are rich... rich as we were more than 10 years ago. Since 2002, folks, it's not the wealth of ours that grew, but the appetite of the State for our wealth.

10/9/2012: Irish Households Debt Overhang: IMF note

IMF published today three papers relating to Ireland's economy. Each of interest on its own merit and I intend to blog about them.

However, here's a chart that actually summarizes pretty well both the extent of the Irish crisis and the sorry state of affairs expected as we exit it:

Here's IMF's explanation for the household deleveraging process out of what is - by the standards of the chart above - a historically unprecedented debt overhang.


"Under the current forecast, households would reduce debt gradually from about  210 percent of disposable income to 185 percent by 2017. Building on the forecast of the
savings rate, the debt path is calculated based on the IMF desk forecast for a muted recovery
of disposable incomes at below GDP growth. Further, the debt path assumes that households use about half of their savings to retire debt, and new lending growth remains moderate, increasing from 1.6  percent of GDP in 2012 to 5.3 percent by 2017."

Now, give it a thought, folks.

1. Irish crisis in mortgages is well in excess of anything represented in the above chart;
2. Irish deleveraging over 9 years (2009-2017) will yield mortgages debt reduction of just 25 percentage points even if we use half of our entire savings to pay down the debts;
3. This painful deleveraging will still Ireland's mortgages markets in wore shape in 2017 than the second worst peak  of the crisis (the UK) back in 2007.

And here's the chart showing that all the debt paydown to-date has had zero effect on arresting the degree of Irish households leveraging (debt/asset value ratio) as underlying asset values of Irish properties continue to fall:

It is clear from the above that the Irish Government is out to lunch when it comes to dealing with the most pressing crisis we face - the crisis of severe debt overhang on households' balancesheets.

6/8/2012: Financial Crises, Recessions and Government Debt

Another interesting chart from The Great Leveraging, by Alan M. Taylor, CEPR DP 9082. This one shows “Excess” Credit Growth (in other words the extent of credit contraction during the crisis) and the Paths of Real GDP in Normal (blue line) and Financial Recession (red line) Contingent on Initial Public Debt Levels.

Here's Taylor's own explanation: Figure 12 from work in progress (Jorda, Schularick, and Taylor, forthcoming) studies the impact of a similar "marginal treatment" [shock of 1% per annum extra loan to GDP growth during the expansion prior to the crisis over an above normal long run levels of growth - and recall that in Ireland's case this rate was probably 3-5 times the shock considered by Jorda et al], subject to starting Government debt/GDP ratio condition (taken as 0% of GDP to 100% of GDP). The central forecast lines - solid lines - provide for assumed 50% of GDP starting assumption for public debt to GDP ratio.

"First look at normal recessions (blue dashed line, dark shaded fan). Extra credit growth in the prior expansion is correlated with mild drag in the recession, say 50-75bps in the central case, but the effect is small, and does not vary all that much when we condition on public debt to GDP levels (the dark fan is not that wide). Now look at financial crisis recessions (red solid line, light shaded fan). Extra credit growth in the prior expansion is correlated with much larger drag, almost twice as large at 100-150bps, and the impact is very sensitive to public debt to GDP levels going in (the light fan is very wide). At public debt to GDP levels near 100% a sort of tailspin emerges after a financial crisis, and the rate of growth craters down from the reference levels by 400bps at the end of the window. Recall, effects in this chart are shown as non-cumulative."

This is serious stuff, folks. In effect the chart above shows that, had Ireland entered the crisis with, say 80% Government debt/GDP ratio, we would have been losing some 2.03% percent on average annually over 6 years. Funny thing - we are, so far on track to exceed this number.

Many say we had a very enviable, low Government debt to GDP ratio at the onset of the crisis - officially - at 44.23% in 2008. Alas, that is platitudinal bull when it comes to hard reality. The problem for the argument involving the 44% figure above is that starting with 2008, Ireland promptly loaded onto the shoulders of the Exchequer massive banks debts, which have pushed Irish Government liabilities up by at least €67 billion, or well above 90% of GDP. Not all of this was taken as debt (NPRF funds) and not all of this was taken as immediate debt (with banks recaps running into 2011), but as far as resources available to combat the crisis go [something that low Government debt at the onset of the crisis should have allowed], banks resolution measures exerted direct drag on Irish Exchequer capacity to use low initial debt levels to fund transition out of the crisis. In other words, as the real data and comparison of it to Taylor's results show, the idea of our low initial starting debt levels being a boom to our situation is bollocks.

Thus, in terms of the chart above, we are closer to 80-90% starting point for debt/GDP ratio for the onset of the crisis period (thanks to Brian Cowen's Government efforts). Which implies that over the 6 years horizon of the crisis, we should expect a cumulative decline in the economy GDP of ca 12%. The fact that over the last 5 years we have seen our GDP declining by 9.52% (using IMF data and 2012 forecast) means only one thing: more pain is yet to come.

1/8/2012: Sunday Times July 29, 2012

An unedited version of my Sunday Times article from July 29, 2012. Please note - this is the last article for the Sunday Times for at least some time to come.

As markets attention shifted from the issues of economic growth to the more immediate crises in Spain, Italy and, once again, Greece, our policy-makers have been basking in a rare spot the sunlight. This week, Irish Credit Default Swaps – insurance contracts on Government bonds – have traded out of the range of the top-10 highest risk economies in the world, for the first time in a number of years. The core driver for this was not something that happened in Ireland, however. Accelerating costs if insuring Italian bonds, helped by margins hikes and ratings agencies warnings, plus the return to CDS markets of Greek bonds have pushed out of the markets spotlight.

With improvement in Irish bonds and CDS contracts relative performance compared to our peers in the peripheral Europe, it has been all too easy for Irish policymakers to forget that the economy is still stalled in the no-man’s land between recession and stagnation. In the short run, the news from the real economy here remain abysmal. But more worryingly, the news continue to reinforce the reality of the entire crisis, compounding already disastrous declines in household wealth, pensions, income and jobs prospects. This compounding means two things for the future. In the near term, it spells no prospect for a recovery in the domestic side of the economy. In the longer run they mean decades of depressed economic growth and a massive black hole of Ireland’s Lost Generation – those born in the late 1960s and into the early 1990s.

The future is truly bleak for the generations of the 30-50-year olds due to the historically massive debt bubble implosion that severely impacted their family balancesheets. The future is grim for today’s 20-year olds who have entered their careers amidst the recession.

Here are the facts.

Irish residents of the cohort of 30-50 years of age are the ones who are carrying the main weight of the household debt accumulated during 2000-2007 period when they either entered the property markets or traded up. According to the data trickling from the banks, these are the families that vastly (some 80% plus) dominating the ranks of high Loan-to-Value Ratio mortgages written against the property valuations that have all but collapsed. This week’s data release by the CSO shows that, measured using mortgages drawdowns, Irish property prices have fallen now 50% on average and 56% in Dublin compared to their peak. Property prices now stand at 35.2% below 2005 levels in terms of comparable data, and are closer to 2000-2001 levels – nominally – based on non-CSO data. And all signs are, the prices are yet to find their bottom.

Using Central Bank data on outstanding credit for house purchases, the implied loss in household wealth relating to the current crisis is currently running at over €90 billion. Taking into the account downpayments, stamp duty and VAT expenditures incurred by the households in purchasing their homes, the true volume of economic losses in the system is closer to €120 billion.

In a normally functioning economy, correcting for the bubble by assuming that house prices appreciation should be running on average at the rate of general inflation, Irish households – purchasers of homes during 2001-2007 period – should have had their net worth rise by a cumulative of ca €45 billion, providing an average retirement support of roughly €35,000 per person in the cohort of 30-50 year olds.

Put differently, even if we cancel out the entire negative equity component of current mortgages, Irish households would require a decade of savings (in excess of debt and remaining mortgages repayments) at roughly 10% annual savings rate to recover the amounts of pensionable wealth they have lost since the onset of the crisis. Adjusting for higher current and future taxes, increased risk of unemployment, and expected higher mortgages interest costs once the extraordinary ECB measures to support liquidity in the euro area banking sector are wound down, Irish middle-age middle class households have been thrown back decades in terms of their ability to finance pensions.

The effects of these wealth declines, however, imply that younger generations will also feel tremendous burden of the crisis. Here is how this intergenerational contagion works.

Firstly, absent pensions provisions, current 30-50 year olds will be delaying their retirement, preventing upward mobility of earnings and career prospects for the younger workers. Secondly, even prior to the crisis Irish pensions system was grossly underfunded with the country facing some of the largest unfunded future liabilities bills in the OECD. These liabilities represent the costs of maintaining current levels of public health, pensions and social welfare provisions commitments under the existent tax system. They do not account for the private pensions shortfalls.

The crisis most likely raised these costs by a significant percentage as pensions-poor households will be forced – in years to come – to rely more extensively on public system. Today’s younger workers will be paying for this through their taxes directly, while indirectly facing additional costs in terms of reductions in expected future benefits. Thirdly, international evidence clearly shows that younger workers entering their careers at the time of a recession experience on average depressed levels of life-time earnings and elevated levels of future unemployment.

It might fashionable today in the Irish media to talk about banks’ customers vs taxpayers squeeze in relation to the high cost of adjustable rate mortgages and trackers subsidization. The reality of our collective insolvency runs much deeper than the immediate crisis within the banking sector. Take a simple exercise in projecting future losses on life-time earnings for current generation of the 20-30 year-olds. On average, these workers could have expected their life-time earnings decline by 8-10 percent compared to those of workers entering the workforce outside a normal recession. At current average earnings, the overall life-time income losses that can be expected by the younger generation amount to some €145-180,000 in current value terms. Per Census data for 2006 population distribution, and using the CSO projected labour force participation rates through 2041, the above range implies a cumulative loss of earnings to the tune of €64-117 billion for the economy as a whole.

Pair these earnings losses for the younger generation with the wealth declines experienced by the middle-aged cohorts and the Lost Generations of Ireland are now on track to a full-blow intertemporal bankruptcy. Both, psychologically and economically, this is a truly disastrous legacy of the boom. And this legacy remains largely hidden behind the rhetoric of our politicians and the media pretending that the negative equity, the wealth destruction and the long-term consequences of the Great Recession will be gone once Ireland’s economy returns to growth. Truth is – the Lost Generations are already here. And they are us.

Box-out:

It appears that the euro zone authorities are frantically pushing through the latest magic bullet solution to the Euro area sovereign debt crisis – the promise of a banking license for the European Stabilization Mechanism (ESM) fund. As conceived, the ESM will have lending capacity severely restricted by the capital held. The banking license, it is argued, will allow the ESM to borrow cheap funds from the ECB (just as the commercial banks are currently doing) and lend these funds out into the distressed banking system for recapitalization of troubled banks. The theory goes that while the markets will not accept leveraging of the ESM capital in excess of ca 7:1, the ECB will have to lend to a ‘bank’ and this can raise the ESM total effective lending capacity from €500 billion to €1 trillion. The problem, of course, is that as with all other previous ‘magic bullet’ solutions, the latest idea is likely to have more disastrous unintended consequences than the original problem it tries to address. Under normal operations the ECB does not lend unlimited amounts to any given bank and when it does lend, the loans are less than 12 months in duration. Thus, should the ESM attempt to borrow via a banking license from the ECB, the entire euro area monetary system will become a farcical cover up for indirect and vast lending to the banks and the sovereigns of the euro zone. Hardly a hallmark of a responsible, and reputationally and legally well-run monetary policy.

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…

Charts:

Sources listed in the charts

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?

23/6/2012: Sunday Times 10/6/2012

This is an unedited version of my Sunday Times article from June 10, 2012.

Last week, the Irish voters approved the new Euro area Fiscal Compact in a referendum. This week, the Exchequer results coupled with Manufacturing and Services sectors Purchasing Manager Indices have largely confirmed that the ongoing fiscal consolidation has forced the economy into to stall. Irish economy’s gross national product shrunk by over 24% on the pre-crisis levels and unemployment now at 14.8%. The most recent data on manufacturing activity shows a small uptick in volumes of production offset by significant declines in values, with profit margins continuing to shrink. Deflation at the factory gates is continuing to coincide with elevated inflation in input prices. In Services – accounting for 48 percent of our private sector activity – both activity and profitability have tanked in May. The Exchequer performance tracking budgetary targets is fully attributable to declines in capital investment and massive taxation hikes, with current cumulative net voted expenditure up 3.3% year on year in May.

On the domestic front, the hope for any deal on bank debts assumed by the Irish taxpayers, one of the core reasons to vote Yes advocated by the Government in the Referendum, has been dented both by the German officials and by the ECB. Furthermore, on the domestic front, the newsflow has firmly shifted onto highlighting the gargantuan task relating to cutting our deficits in 2013-2015 and the problem of future funding for Ireland.

Per April 2012 Stability Programme Update, Ireland’s fiscal consolidation path will require additional cuts of €5.55 billion over the next three years and tax increases of at least €3.05 billion. Combined, this implies an annual loss of €4,757 per each currently employed worker, equivalent to almost seven weeks of average earnings. This comes on top of €24.5 billion of consolidations delivered from the beginning of the crisis through this year. The total bill for fiscal and banking mess, excluding accumulated debt, to be footed by the working Ireland will be somewhere in the region of €18,309 per annum in lost income.

This has more than a tangential relation to the Government’s main headache – weaselling out of the rhetorical corner they put themselves into when they solemnly promised Ireland’s ‘return to the markets’ in 2013 as the sole indicator for our ‘regained economic sovereignty’.

Even assuming the Exchequer performance remains on-target (a tall assumption, given the headwinds of economic slowdown and lack of real internal reforms), Ireland will need to raise some €36 billion over 2013 and 2014 to finance its 2014-2015 bonds rollovers and day-to-day spending. In January 2014 alone, the state will have to write a cheque for €8.3 billion worth of maturing bonds. The rest of 2014 will require another €7.2 billion of financing. Of €36.5 billion total, €19.3 billion will go to fund re-financing of maturing government bonds and notes, plus €6.9 billion redemptions to Troika. Rest will go to fund government deficits.

At this stage, there is not a snowball’s chance in hell this level of funding can be secured from the markets, given the losses in economy’s capacity to pay for the Government debts. Which means Ireland will require a second bailout. And herein lies the second dilemma for the Government. Having secured the Yes vote in the Referendum of the back of scaring the electorate with a prospect of Ireland being left out in the cold without access to the ESM, the Government is now facing a rather real risk that the ESM might not be there to draw upon. In fact, the entire Euro project is now facing the end game, which will either end in a complete surrender of Ireland’s economic and political sovereignty, or in an unhappy collapse of the common currency.

The average cumulative probability of default for the euro area, ex-Greece, has moved from 24% in April to 27.5% by the end of this week. For the peripheral states, again ex-Greece, average cumulative probability of default has risen from 45% to 52%.

Euro peripherals, ex-Greece: 5-year Credit Default Swaps (CDS) and cumulative probability of default (CPD), April 1-June 1

Source: CMA and author own calculations

These realities are now playing out not only in Ireland and Portugal, but also in Spain and Cyprus.

Spain has been at the doorsteps of the Intensive Care Unit of the euro area for some years now. Yet, nothing is being done to foster either the resolution of its banking crisis, nor to alleviate the immense pressures of it jaw-dropping 24.3% official unemployment rate. Deleveraging of the banks overloaded with bad loans has been repeatedly pushed into the indefinite future, while losses continue to accumulate due to on-going collapse of its property markets. At this stage, it is apparent to everyone save the Eurocrats and the ECB, that Spain, just as Greece, Ireland and Portugal, needs not loans from the EFSF/ESM funds, but a direct write-off of some of its debts.

Spain’s problems are immense. On the upper side of estimated demand for European funds, UBS forecasts the need for €370-450 billion to sustain Spanish banking sector and underwrite sovereign financing and bonds roll-overs. Mid-point of the various estimates is within the range of my own forecast that Spanish bailout will require €200-250 billion in funds, a move that would increase country debt/GDP ratio to 109.9% in 2014 from current forecast of 87.4%, were it to be financed out of public debt, as was done in Ireland or via ESM.

Overall, based on CDS-implied cumulative probabilities of default, expected losses on sovereign bonds of the entire EA17 ex-Greece amount to over €800 billion, or well in excess of 160% of the ESM initial lending capacity.

Europe is facing three coincident crises that are identical to those faced by Ireland and reinforce each other: fiscal imbalances, growth collapse, and a banking sector crisis.

Logic demands that Europe first breaks the contagion cycle that is seeing banking sector deleveraging exerting severe pressures and costs onto the real economy. Such a break can be created only by establishing a fully funded and credible EU-wide deposits insurance scheme, plus imposing an EU-wide system of banks debts drawdowns and debt-for-equity swaps, including resolution of liabilities held against national central banks and the ECB.

Alongside the above two measures, the EU must put forward a credible Marshall Plan Fund, to the tune of €1.75-2 trillion capacity spread over 7-10 years, with 2013 allocation of at least €500 billion. This can only be funded by the newly created money, not loans. The Fund should disburse direct monetary aid to finance private sector deleveraging in Spain, Ireland and to a smaller extent, Portugal. It should also provide structural investment funds to Greece, Italy and Spain, as well as to a much lesser extent Ireland and Portugal.

The funds cannot be allocated on the basis of debt issuance – neither in the form of national debts, nor in the form of euro bonds or ESM borrowings. Using debt financing to deal with the current crises is likely to push euro area’s expected 2013 debt to GDP ratio from 91% as projected by the IMF currently, to 115% - well above the sustainability threshold.

The euro area Marshall Plan funding will require severe conditionalities linked to long-term structural reforms. Such reforms should not be focused on delivering policies harmonization, but on addressing countries-specific bottlenecks. In the case of Ireland, the conditionalities should relate to reforming fiscal policy formation and public sector operational and strategic capabilities. Instead of quick-fix cuts and tax increases, the economy must be rebalanced to provide more growth in the private sectors, improved competitiveness in provision of core public services and systemic rebalancing of the overall economy away from dependency on MNCs for investment and exports.

Chart: Euro Area: debt crisis still raging

Source: IMF WEO, April 2012 and author own calculations

The core problem with Europe today is structural policies psychosis that offers no framework to resolving any of the three crises faced by the common currency area. Breaking this requires neither harmonization nor more debt issuance, but conditional aid to growth coupled with robust resolution mechanism for banking sector restructuring.

Box-out:

This week’s decision by the ECB to retain key rate at 1% - the level that represents historical low for Frankfurt.  However, two significant developments in recent weeks suggest that the ECB is likely to move toward a much lower rate of 0.5% in the near future. Firstly, as signalled by the euro area PMIs, the Eurozone is now facing a strong possibility of posting a recession in the first half of 2012 and for the year as a whole. Secondly, within the ECB governing council there have been clear signs of divergence in voting, with Mario Draghi clearly indicating that whilst previous rates decisions were based on a unanimous vote, this time, decision to stay put on rate reductions was a majority vote. A number of national central banks heads have dissented from previous unanimity and called for aggressive intervention with rate cuts. In addition, monetary dynamics continue to show continued declines in M3 multiplier (which has fallen by approximately 40 percent year on year in May) and the velocity of money (down to just under 1.2 as opposed to the US 1.6). All in, the ECB should engage in a drastic loosening of the monetary policy via unsterilized purchases of sovereign debt and cutting the rates to 0.25-0.5%, with a similar reduction in deposit rate to 0.25% to ease the liquidity trap currently created by the banks’ deposits with Frankfurt. The ECB concerns that lower rates will have adverse impact on tracker mortgages and other central bank rate-linked lending products held by the commercial lenders is misguided. Lower rate will increase banks’ carry trade returns on LTROs funds, compensating, partially, for deeper losses on their household loans.