31/12/2013: Debt and Growth: Consumption Crowding-Out Channel

Since the overhyped and outright hysterical 'controversy' over the Reinhart & Rogoff debt thesis blew up across the media earlier this year (I covered much of the controversy on the blog and in my columns, for example, here http://trueeconomics.blogspot.ie/2013/07/272013-village-june-2013-real-effects.html), it became - to put it mildly - unfashionable to reference the adverse effects of debt on growth and economy. Too bad, some economists seem to have missed that point.

A new study from the Korea Institute for International Economic Policy, titled "Nonlinear Effects of Government Debt on Private Consumption in OECD Countries" (see citation below) looked at "nonlinear effects of government debt on private consumption in 16 OECD countries. The estimated consumption function shows smooth regime switching depending on the debt-to-GDP ratio, and the threshold level of regime switching is found to be the ratio of 83.7 percent. The results reveal that a higher level of government debt crowds out private consumption to a greater extent, and that the degree of the crowding out effect has deteriorated since the global financial crisis."

Wait, there are thresholds here… 83.7% debt/GDP ratio - very close to the  S. Cecchetti, M. Mohanty and F. Zampolli thresholds (see http://trueeconomics.blogspot.ie/2011/09/26092011-irelands-debt-overhang.html). And there is the 'causal link' between debt and growth via crowding out of private consumption.

10/10/2013: IMF's GFSR October 2013: Focus on Corporate Debt Overhang

I'll be blogging out today some interesting charts from the IMF's GFSR October 2013... these will appear in no particular order, with brief summaries...

Here's a start: non-financial corporate sector debt crises in the euro periphery. I always noted that the important issue in the current crisis is not just a traditional sovereign debt crunch, but the debt overhang over what I call the total real economic debt: household, non-financial corporate and government debts.

In the above that Irish banks offer lower rates, based on the bank capital and reserves ratio to NPLs than other banks, including Portugal, Italy and Spain. Also note that 5 years into the crisis and after massive recapitalisations Irish banks buffers are lower than for any other economy, save Cyprus and Greece. That is the cost of delaying resolution of the loans.

Note: my latest article on European and Irish banking systems is available here: http://trueeconomics.blogspot.ie/2013/10/9102013-leveraged-and-sick-euro-area.html

The next four charts show that quality of loans to non-financial corporate sector is deteriorating and remaining poor for firms in the periphery, while improving for German and French firms.

Most worrying is the Italian situation where quality of loans is continuing to deteriorate and the rate of deterioration is accelerating, while Spanish situation remains exceptionally weak:

Things are desperate-to-dire in Greece and Portugal too:

More to come, so stay tuned...

17/6/2013: On Debt of the Nations & Euro Crisis: 2 links

Update from the ZeroHedge on the Debt of the Nations: http://www.zerohedge.com/news/2013-06-04/debt-nations

Worth a read!

And while on the case of crises (for whatever you might read about Reinhart and Rogoff debate, debt overhang is a crisis) we have an excellent contribution by Dani Rodrik on solutions for the Euro area crisis: http://www.project-syndicate.org/commentary/saving-the-long-run-in-the-eurozone-by-dani-rodrik

Thought-provoking and comprehensive summary (albeit I do not necessarily agree with all of Rodrik's conclusions).

5/6/2013: The economics of Lost Generations: Sunday Times 16/5/2013

This is an unedited version of my Sunday Times column from May 16, 2013


Not known for its 'ahead of the pack' thinking and bruised by recent controversies, nowadays, the ESRI focuses on a more retrospective in-depth analysis of the trends shaping Irish economy and society. Aptly, this week's most talked-about Irish research note was ESRI paper on the impact of the crisis on households. Covering data through 2009/2010, it offers both a fascinating look into economics of our lost generations, and a reminder that it takes official Ireland at least 3 years before everyday reality gets translated into policy-shaping analysis.

The topic is close to my heart: back in 2010 and then in 2012, in these very pages, I wrote about the fact that Ireland is facing not one, not two, but a number of lost generations covering those under the age of 50. Things only got worse since.

The crises we face continue to destroy lives and wealth of the 35-50 year-olds, who mortgaged their future back in 2003-2007. Pensions and savings are gone, psychological and social wellbeing is under unrelenting pressure from the threat of unemployment, losses in after-tax disposable income, negative equity, the banks' push to extract revenues from borrowers, and the internecine policies adopted by the Government.

Housing wealth and negative equity exact the greatest toll. Housing wealth accounted for over 3/4 of the total real disposable wealth that formed the bedrock of pensions provisions in the years before the crisis hit. This has now tumbled by over half, once taxes and property prices declines can be factored in.

Income losses are not far behind. Not withstanding the effects of tax increases, an average working age family in this country lost close to EUR100,000 in income between the beginning of 2008 and the end of 2012.

Much of these losses were accumulated by the prime working age group of 35-50 year-olds. Adjusting for changes in population and unemployment in these groups, relative to the rest of the country population, the opportunity cost of foregone savings, and adding the impact of tax increases, the real disposable income declines during the crisis run somewhere closer to EUR120,000 per family with two working adults in the 30-50 years of age group. When you consider the losses in housing wealth over the life time, and interest costs on negative equity components of mortgages, the total real life-time losses due to the crisis easily reach over EUR200,000 per family. This number assumes expected house prices appreciation in line with 2% annual inflation from 2013 on, but excludes effects of future tax hikes.

And more tax hikes are coming still. The Government might boast that ‘most of the adjustment is behind us’. Alas, IMF’s latest forecasts for the Irish economy clearly show that by 2018, compared to 2012, Irish Government tax take needs to increase by EUR12.5 billion per annum. Of these, EUR8.7 billion in revenue will come from personal income taxes and VAT. For comparison, between 2009 and 2012 receipts from these two tax heads rose only EUR2.9 billion. Social Insurance contributions are required to rise by EUR2.2 billion in 2013-2018, against the decline of EUR2.6 billion recorded in 2009-2012.

The ESRI research, published this week, does not go as far as attaching real numbers to the losses sustained by Irish households, but it does conclude that "income and consumption increase roughly steadily for the average household over the age of 45 from 1994/95 to 2009/10. ...In sharp contrast to the increase in earning and expenditure of older households over the last two decades, there has been a large drop in income and consumption for the younger average household in the crisis. Between the 2004/05 survey and that of 2009/10, real disposable income decreased by 14 per cent, real consumption including housing by 25 per cent and excluding housing by 32 per cent."

In other words, at the end of 2012, gross investment in the Irish economy stood at the levels below those in 1997, domestic demand at mid-2003 levels and private domestic demand (excluding Government spending) at the levels last recorded in 1998.

The future looks bleak for today's 30-50 year-olds even beyond income declines and the negative equity considerations. Per ESRI, "Mortgages are most prevalent in the 35-44 year bracket, with more than half of households in this group having a mortgage. About 43 per cent of the households aged 25 to 34, and 45 per cent of those aged 45 to 54 are mortgage holders as well." In other words, those in 30-50 years of age cohorts are in the worse shape when we consider housing wealth.

The ESRI fails to note that these households are also facing a very uncertain future when it comes to the cost of funding their mortgages.

Currently, ECB benchmark rate stands at 0.50%, which is miles below the pre-crisis period average of 3.10%.. At some point in time, Germany and other core European economies will be back delivering the rates of growth comparable to those seen over 2002-2007 period and the ECB rates will inevitably rise. At the same time, Irish banks will be carrying an ever-worsening book of household loans. With every year, average mortgage vintage on banks books moves closer and closer to 2006-2007 peak market valuations, as better quality older mortgages are being paid down. As real estate prices continue to signal zero hope of a rapid recovery, Irish banks will have to keep margins well above pre-crisis averages. Failing SMEs loans and Basel III capital hikes add to this pressure.

This week IMF released a set of research papers focusing on expected paths for unwinding extraordinary monetary policy measures deployed by the central banks around the world. Their benchmark scenario references interest rates increases of 2.25% for longer maturities and the adverse scenario a 3.75% rates hikes. Were the benchmark scenario to play out, mortgages rates can jump by over 2 percentage points on today's rates, before the increases that would be required for capital supports.

For mortgages of 2003-2007 vintage a return to historical levels of ECB rates combined with higher lending margins will spell a disaster.

Put simply, anyone who thinks the worst is now behind us should heed the warning: wealth destruction wrecked by the property bubble collapse is yet to run its full course.

The ESRI report doesn't tell us much about the expected effects of the crisis on our youngest working-age cohorts of 18-25 year olds. Truth is they too count as Ireland's Lost Generation.

Lower incomes and higher debt burdens of the 30-50 year-olds will translate into longer working careers and less secure retirement. For the younger generations, this means fewer promotional opportunities and reduced life-time earnings in the future, as well as higher tax burden to care for the under-pensioned older generation. The disruption and delays in access to career-building early jobs will also cost dearly. Many of today’s graduates of the universities with professional degrees and skills face rapid depreciation of their earnings when they delay entry into the professions.

Our economy’s re-orientation toward ICT services is an additional risk factor. Recent research points to an alarmingly high rate of skills depreciation in ICT services sectors, with declining employability of those in late 30s and early 40s compared to their younger counterparts. Likewise, worldwide and in Ireland, the earnings premium, even adjusting for the risk of unemployment, associated with education is now much smaller than in the late 1990s - early 2000s.

In short, today's young face lower life-time real earnings, higher life-time burden of taxation and dramatically reduced value of intergenerational wealth transfers (or put simply -inheritance).

The ESRI attributes younger households' aggressive cuts in consumption during the crisis to the bottlenecks in credit supply, parrot-like mimicking the Government assertion that if only the banks were lending again, things will miraculously return to normal. The reality on the ground is different. Irish society has been hit by a series of inter-related crises that not only reduced credit supply to younger households, but made household balance sheets insolvent by a combination of high debt, reduced life-time disposable incomes and wiping out middle and upper-middle classes wealth.

The only solution to these crises is to help repair households' balance sheets by helping them to deleverage their debts faster and a lower cost. This can be achieved solely by lowering tax burden on the households and aggressively writing down unsustainable levels of debt. Like it or not, were the banks to start lending tomorrow, even ignoring the fact that the cost of credit is only going to climb up in the future, the impact this will have on the economy and Irish households will be negligible.

Two successive Irish Governments have spent over 5 years throwing scarce resources on repairing the banks. It is time to realize that doing more of the same and expecting a different outcome is not bright policy to pursue. It is time to focus on what matters most in any economy – people.

Box-out:

This week, the IMF published its Article IV assessment of Malta’s economic conditions. The study expresses one major concern about the risks faced by the Maltese economy in the near future that is salient to the case of Ireland, yet remains unvoiced in the case of our assessments by the Fund. Quoting from the release: "In the longer term, regulatory and tax reform at the European or global level could erode Malta’s competitiveness. The Maltese economy, including the financial sector and other niche services, has greatly benefitted from a business-friendly tax regime. Greater fiscal integration of EU member states and potential harmonization of tax rates could erode some of these benefits, with consequences on employment, output, and fiscal revenues."

Ireland is a much more aggressively reliant on tax arbitrage than Malta to sustain its economic model and has been doing so for far longer than Malta. Both, our modern manufacturing and traded services sectors are virtually captive to the foreign multinationals reliant on tax arbitrage opportunities to domicile here. Yet, neither the IMF, nor any other member of the Troika seem to be concerned about the prospect of tax reforms in Europe and elsewhere in the context of Irish economy. May this be because the elephant in the room (our reliance on tax arbitrage) is simply too large to voice in the open?

28/5/2013: US Gen-Xers are Screwed... but Not as Much as the Irish Ones

Here is what the brain-dead Irish political and business 'elites' should read every time they talk about negative equity not being a big problem 'until you move house' & debt being sustainable 'until you can't repay loans'. The wealth destruction wrecked on Irish mid-generation families is so much more comprehensive than that for the US Generation-X households, and the debt levels loaded onto the shoulders of Irish households (private and public) are that much more extensive than those for the US Gen-Xers, and yet,

• Irish politicians are incapable of comprehending the effects of wealth destruction and are solely obsessed with public finances; while
• Irish business elites are mumbling left-right-and-centre about the need to 'free' people from their savings to 'get economy going again'.

Read this, morons:
http://www.businessinsider.com/generation-x-least-prepared-for-retirement-charts-2013-5#debt-is-killing-them-too-gen-xers-carried-more-than-80000-worth-of-debt-by-2010-on-the-flip-side-depression-era-babies-had-zero-debt-and-war-babies-had-just-15000-to-worry-about-7

25/4/2013: IMF's 'End of Austerity' Napkin Sketch Is Soggy Wet

IMF catches up with 'End Austerity' bandwagon and overtakes the EU 'policymakers' in providing a general blueprint. From today's comments by IMF First Deputy Managing Director David Lipton (emphasis is mine):

"...Europe needs to act on several fronts. Countries will need to have clear and specific commitments to medium-term fiscal consolidation, with the appropriate pace to be evaluated on a case-by-case basis. Careful consideration should also be given to the composition of fiscal measures. The European Central Bank (ECB) should maintain its very accommodative stance, he said, but noted that eliminating financial fragmentation – whereby households and companies in some countries face clogged credit channels and lending rates well above those in the core – will probably require the ECB to implement some “additional unconventional measures.”

So the Fiscal Compact of 'One Policy Target & Timeframe Fit All' is out of the window then? If timeframe (pace) were to be set on a case-by-case basis, there is hardly any real discipline left. Here's why. Suppose Italy takes slower path to deflating debt levels to the target of 60% than that mandated by the Fiscal Compact (FC) (5% adjustment per annum). France, then, can demand either a slower pace for its drawdown of debt or it can opt to demand slower reductions in deficits. Which means Spain will also have its list of requests ready, all in breach of the FC.

"As we see it, countries that can afford to support the economy need to do so—but in ways that encourage the private sector to invest and boost demand..."

Ok, but what does it mean? AAA countries borrowing to stimulate? Suppose they succeed. What happens to growth rates and income levels in Euro area? Right - divergence will be amplified and with it, mismatch of monetary and FX policies too. 

Per paying attention to the composition of fiscal measures: it is a fine objective. Except in the case of European leaders, this means, usually, hiking taxes even more instead of cutting spending. IMF knows that this is counterproductive, but whilst correctly arguing that policies should be reflective of heterogeneity between member states' economies, IMF is incorrectly ignoring the political reality of Europe, where more spending = good, lower taxes = bad.

More: "Another country responsibility is better structural policies. Countries should press on to tackle long-standing rigidities in order to raise medium-term growth prospects. Southern Europe, and even some of the core, needs to increase its competitiveness in the tradeable goods sector, especially through labor and product market reforms. So far, much of the reduction in current account deficits has come because demand is sluggish.  For a stronger, sustained improvement -- enough to boost exports that will create jobs for the unemployed -- countries need a broader and more durable improvement in competitiveness, based on structural reform. In Northern Europe, even where national competitiveness is not the issue, reforms could help generate a more vibrant services sector."

Again, usual tool kit deployed by the IMF: structural reforms are needed (no real innovation as to what these might be) and exports must be increased (who will be buying these exports in the world where every country is being told by the IMF to increase its exports?).

I wonder why would Mr Lipton label ECB current stance as being accommodative. ECB interest rate is above G7 average and ECB's 'panacea' of OMT is yet to make any real purchases. ECB has attempted to sterilise all past 'accommodative' interventions and is now pleased with winding up LTROs. In brief, setting aside war-time rhetoric from the ECB, Frankfurt is accommodating very little.

One has to agree with the need to eliminate financial fragmentation, but IMF is fully aware that European system will have to continue deleveraging. There is too much debt in the pipeline to de-clog it by simply pushing through more credit at lower cost.

"...the Single Supervisory Mechanism [is] “a key step” and ...the IMF supports a market-based bail-in approach as being considered in the European Union Directive on Bank Recovery and Resolution, which would require banks to hold a minimum amount of securities with features that permit them to be written-off or converted to equity if capital buffers fall too low..."

So getting Cyprused is  the future for Europe, then.

Mr Lipton is dead on right, saying that "In our preoccupation with sovereign debt, we tend to overlook the huge overhang of private debt in some countries that could be a deadweight on demand and bank balance sheets for a long time. We’ve already seen the hit that households have taken in the periphery economies because of the sharp correction in home prices (e.g. Ireland). This could only worsen without renewed growth (e.g. Spain, Belgium and the Netherlands)." And more: "On the corporate side, we know how much the level of debt has increased over the past decade, particularly in the periphery. We elaborated on this development in our recent Global Financial Stability Report.  ...Measured on a debt-to-equity basis, a portion of Italy's corporate sector is rising into stressed levels. In the event of a prolonged stagnation, corporate profits would slacken further, putting pressure on companies to deleverage and increasing the risk of debt distress. Corporates are not being helped by bank retrenchment back into home markets. This is most pronounced from the periphery; French and German banks reduced their exposures to these markets by some 30-40 percent between mid 2011 and the third quarter of last year."

Conclusion (relevant to 'being Cyprused' above): "None of this bodes well for banks in a stagnation scenario. They are already weak. But higher levels of corporate and household defaults and credit losses would threaten a second round of bank balance sheet deterioration."

Net result: IMF has no new ideas on what to do if 'austerity' path were to be altered. There's a good reason as to why they don't - borrowing cash to burn it on Government spending (traditional European way) is out of question, given the risk of raising costs of borrowing, slow growth and higher interest bills that await. And using monetary policy to full extent is infeasible because IMF has no hope for ECB in its current state.

'Austerity' might be overdone, but 'Not Austerity' is unlikely to be any different...

23/4/2013: Ignore Europe's Debt Crisis at Your Own Peril

In recent days it became quite 'normal' to bash 'austerity' and talk about debt overhang as the contrived issue with no grounding in reality. Aside from the arguments of those worked up about Reinhrat & Rogoff (2010) paper (ignoring all other research showing qualitatively, and even quantitatively similar results to theirs), there is a pesky little problem:

• Debt has physical manifestation (albeit an imperfect one) in the form of banks (lenders) balancesheets. 

As the result of this pesky problem, we can indeed gauge (again, an imperfect translation, but better than none) the effect of repairing these balancesheets on the supply of credit, thus on investment, and thus on real economic activity.

Here are 2012 IMF estimates of the effects of the euro area banks deleveraging on the real economy:

'Weak policies' in the above are what we currently pursuing - with monetary and fiscal policies mismatch. And the negative effect of the declines runs past 2017 in the case of the heavily-indebted peripheral states. Cumulated decline estimated, relative to baseline GDP forecasts, is almost 12% over 5 years. Which over 20 years (average duration of the debt crises episodes) runs closer to 0.7% of GDP loss per annum due to banks deleveraging, aka due to banks managing debt levels on their own balancesheets.

The above chart is based on banking sector lending alone, excluding effects from deleveraging by other investors and financial intermediaries, and excluding effects of non-EU banks deleveraging or effects of the non-EU banks exits from the euro area. With these in place, the adverse effects can probably reach beyond 1% mark.

19/2/2013: Japan's Woes: 3 recent posts

Some excellent blogposts on Japan's problems via Economonitor:

1) All exports and money printing can't offset Japan's debt, ageing and domestic demand woes: http://www.economonitor.com/edwardhugh/2013/02/12/japans-looming-singularity/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20End%20Games

2) Does end of growth (Japan's example) spell end of high quality of life? http://www.economonitor.com/dolanecon/2013/02/15/growth-and-quality-of-life-what-can-we-learn-from-japan/

3) Japan's forgotten (but not fully unwound) debt bubble: http://www.economonitor.com/blog/2013/01/the-setting-sun-japans-forgotten-debt-problems/

All worth a read.

I can add that in 2011 Quality of Life Index by International Living magazine, ranking 191 countries around the world, Japan was in 7th place (rank range is between 7th and 10th), whilst Ireland was in 20th (rank range between 20th and 26th) in terms of overall quality of life, with Japan outperforming Ireland in 4 out of 9 categories of parameters on which the rankings were based and tying Ireland in one category. (link to full rankings)

Note: the above rankings did throw some strange results, so careful reading into them.

20/8/2012: Hungary - a country that can't?..

An interesting blogpost by Professor Steve Hanke on Hungarian economy's adventures in the crisis land.

Here's another look at Hungary (all data is via IMF WEO). Green boxes show ranges of values required for Hungary to effectively converge in economic development with top EU12 states and those that are consistent with long-term sustainability of public finances.

Fron the first chart it is clear that Hungary did well during the period from 1997 through 2006 in terms of real economic growth, but severely underperformed in terms of external balances. In fact, for the period 1995-2017 (incorporating IMF latest forecasts) Hungary operates within its means (in terms of current account balance) in only 4 years.

While current account deficit remained steady at worse than -7.0% of GDP in 1998-2008, little of this relates to investment supports. In fact, current account deficits vastly exceed the portion of the economic investment not financed by savings.

Per chart above, it is also clear that Hungarian investment has declined precipitously, as a share of GDP, from the peak 27.65% in 1998 to 23.54% in 2008 and fell to around 18% from 2012 on. Meanwhile, savings too trended down over the period 1995 through 2017. The economy is becoming less and less capable of generating investment-driven growth (and that is ignoring the issues of credit supply in the banking system etc).

Hungary's Government debt was relatively benign, compared to many european counterparts during the period of 1997-2006. However, the metric used (debt around 60% of GDP) ignores the reality of an economy that is still in catching up with the more advanced European states (including some post-transition economies, such as Czech Republic and Slovenia) in terms of income per capita and other macroeconomic parameters. Such catching up can only be aided by lower debt to GDP ratios and more investment.

In line with external deficits highlighted above, Hungary has run some extremely severe imbalances on both structural government deficit and net government borrowing (ordinary deficit) sides, as shown in the chart below. In terms of government deficit, Hungary was in the red, on average by 3.48% of GDP in the period pre-accession to the EU. Between 2001 and 2007 the deficit averaged massive 6.92% annually, declining to 2.3% of GDP in 2008-2012. The benign level of current deficit (2012 expected deficit of 3% of GDP comes on top of surplus of 3.96% in 2011) is only highlighting the fact that short-term corrections are no substitute for longer-term prudence. Between 1995 and 2012, Hungarian Government was operating within 3% deficit criterion for only 2 years.

Cumulated, the twin current and government deficits from 2000 on through 2012 are severe:

All of this suggests that Hungary suffers (at 80.45% of GDP in 2011) from a classic debt overhang problem exacerbated by the long-term poor performing fiscal deficits and current account dynamics. That these effects should be felt even at the level of debt traditionally considered to be relatively benign (Hungary's 5-year average Government debt through 2012 stands at 78% of GDP compared to 62% for the 5 year period between 2003 and 2007) is probably best explained by the country relatively lower ability to sustain even these levels of debt.

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.

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.

25/5/2012: Why I don't like Eurobonds

Three reasons I don't like the idea of the Eurobonds:

1. Issuing Eurobonds to swap for existent Government debt is equivalent to attempting to treat debt overhang by relabeling the debt. While it might reduce the interest burden on the sovereigns suffering from more severe debt overhang, but that is a relatively shallow improvement, especially given that the heavier-indebted sovereigns are already being financed or about to be financed from a collective funding source of ESM.
2. Issuing Eurobonds to create capacity for new borrowing is equivalent to fighting debt overhang with more debt. In addition to being seriously problematic in terms of logic, there is also a capacity constraint. Eurozone will sport 89.964% debt/GDP ratio this year and under current IMF projections this debt will remain above 90% (+/-1%) bound for 2012-2015. At these levels, debt exerts long term drag on future growth potential for the Euro area as a whole. And this region doesn't have much of cushion in terms of growth rates to sustain such drag.
3. Issuing Eurobonds to generally drive down or harmonize the borrowing costs across the EA will simply replicate the very same conditions of cheap credit misaligned with relative sovereign risks that have been instrumental in creating the current crisis during the loose monetary policy pursued by the ECB. Except with a major difference this time around - loose credit costs will only apply to one side of the economy, namely the Public Sector. This is double troubling, because, in my view, it is the nature of the European disease that our policymakers are incapable of thinking about growth outside that supported by subsidies and neo-protectionism vis public expenditure. 

For these three reasons (not to mention lack of political infrastructure and the fact that once borrowing costs come down the sovereigns will simply engage in diverting 'savings' achieved to priming the public spending pump once again, setting their economies up for the scenario of lax structural reforms and raising the risk of increasing the strength of automatic fiscal destabilizers in the future cyclical downturns) I do not think Eurobonds represent a correct approach to dealing with this crisis.

Nor do I think it is reasonable to label Eurobond issuance a 'burden-sharing', unless Eurobonds are raised by a fully federal power presiding over the entire Euro Area - a power that is hard to imagine emerging for a number of reasons, including that Euro area is only a subset of a broader EU27 block.

I am with the Germans on this one - Eurobonds are a dangerous illusion of a solution.

Update: an interesting side-proposal is contained here. And a polar opposite to that - the senile ideas of one ex-ECB chief here.

19/3/2012: Debt and Unfunded Obligations

Chart of the day (updated):

Sources: http://www.ncpa.org/pdfs/st319.pdf and author own calculations. Update covers latest IMF estimates for GDP change 2009-2011 and rebasing of all liabilities to 2011.

26/02/2012: What happens when debt is too high and taxes are distortionary?

An interesting paper: Public Debt, Distortionary Taxation, and Monetary Policy by Alessandro Piergallini and Giorgio Rodano from February 7, 2012 (CEIS WorkingPaper No. 220 ).

In traditional literature, starting with Leeper’s (1991):

• if fiscal policy is passive (so that it simply focuses on a guaranteed / constitutionally or legislatively mandated public debt stabilization irrespectively of the inflation path), 
• then monetary policy can independently be set to focus solely on inflation targeting (ECB) ignoring real economy objectives, such as, for example, unemployment and growth targeting. 

The twin separate objectives of fiscal and monetary policy can be delivered by following the Taylor principle. This means if the monetary authorities observe an upward rise in inflation, they can hike nominal interest rates by greater proportion than the rise in inflation. This is feasible, because in the traditional setting, fiscal policy objective of sustaining public debt at stable levels can be achieved - in theory - by raising non-distortionary taxes that are not linked to inflation (for example, distortionary VAT and sales taxes yield revenues that are linked to inflation, so monetary policy to reduce inflation will lead to reduced economic activity and reduced revenues for the Government at the same time; in contrast, non-distortionary lump sum taxes yield fixed revenue no matter what income or price level applies, so that anti-inflationary increase in the interest rates is not going to have any impact on tax revenue).

Of course, if fiscal policy is active (does not focus on debt stabilization), monetary policy under Taylor rule should be passive (so interest rates hikes should of smaller percentage than inflationary spike). Such passive monetary policy will allow Governments to inflate their tax revenues without raising rates of distortionary taxation and

In many real world environments Governments, however, can only finance public expenditures by levying distortionary taxes (progressive taxation). So in this environment, the question is - what happens to the 'passive fiscal - active monetary' policies mix? According to Piergallini and Rodano, "It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate."

Ok, what does this mean? It means that if you want passive rules (public debt targeting - e.g. fiscal compact EU is trying to legislate) you need inflation (to transfer funds to the Government from the private individuals and companies).

Per authors: "The analytical results derived in this paper give theoretical support to the argument recently advanced by Cochrane (2011) and Davig, Leeper and Walker (2011) that the large fiscal deficits decided by governments to offset the crisis can lead to the “Laffer limit” beyond which inflation must endogenously jump up according to the fiscal theory of the price level."

Now, we often hear the arguments that in the near term there will be no inflation as slow growth will prevent prices from rising. Sure, folks. Good luck with that.