19/4/15: The costs of deflations: a historical perspective

An interesting article from the BIS on the impact of deflation risks on growth and post-crises recovery. Authored by Borio, Claudio E. V. and Erdem, Magdalena and Filardo, Andrew J. and Hofmann, Boris, and titled "The Costs of Deflations: A Historical Perspective" (BIS Quarterly Review March 2015: http://ssrn.com/abstract=2580289), the paper looks at the common concern amongst the policymakers that falling prices of goods and services are very costly in terms of economic growth.

The authors "test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt."

But there is much more than this to the paper. So some more colour on the above.

"Concerns about deflation [are] …shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion."

Do note that I have been challenging this thesis for some time now, precisely on the grounds of: 1) causality (deflation being caused by weak growth, not the other way around) and 2) link between corporate and household debt and deflation via monetary policy / interest rates channel.

Per authors, "The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output."

Besides the supply side argument, there is more: "…even if deflation is seen as a cause, rather than a symptom, of economic conditions, its effects are not obvious. On the one hand, deflation can indeed reduce output. Rigid nominal wages may aggravate unemployment. Falling prices raise the real value of debt, undermining borrowers’ balance sheets, both public and private – a prominent concern at present given historically high debt levels. Consumers might delay spending, in anticipation of lower prices. And if interest rates hit the zero lower bound, monetary policy will struggle to encourage spending. On the other hand, deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive."

Note: the authors completely ignore the interest cost channel for debt.

Meanwhile, "…while the impact of goods and services price deflations is ambiguous a priori, that of asset price deflations is not. As is widely recognised, asset price deflations erode wealth and collateral values and so undercut demand and output. Yet the strength of that effect is an empirical matter. One problem in assessing the cost of goods and services price deflations is that they often coincide with asset price deflations. It is possible, therefore, to mistakenly attribute to the former the costs induced by the latter."

The BIS paper analysis is "based on a newly constructed data set that spans more than 140 years, from 1870 to 2013, and covers up to 38 economies. In particular, the data include information on both equity and property prices as well as on debt."

The study reaches three broad conclusions:

• "First, before accounting for the behaviour of asset prices, we find only a weak association between goods and services price deflations and growth; the Great Depression is the main exception."
• "Second, the link with asset price deflations is stronger and, once these are taken into account, it further weakens the association between goods and services price deflations and growth."
• "Finally, we find some evidence that high private debt levels have amplified the impact of property price deflations but we detect no similar link with goods and services price deflations." Note: this means that the ECB-targeted deflation (goods and services deflation) is a completely wrong target to aim for in the presence of private debt overhang. Just as I have been arguing for ages now.

Let's give some more focus to the paper findings on debt-deflation links: "Against the background of record high levels of both public and private debt (Graph 7 below), a key concern about the output costs of goods and services price deflation in the current debate is “debt deflation”, ie the interaction of deflation with debt."

"The idea is that, as prices fall, the real debt burden of borrowers increases, inducing spending cutbacks and possibly defaults. This harks back to Fisher (1933), who coined the term.16 Fisher’s concern was with businesses; today the focus is as strong, if not stronger, on households and the public sector. This type of debt deflation should be distinguished from the strains on balance sheets induced by asset price deflations. This interaction has an even longer intellectual tradition and has been prominent in the public debate ever since the re-emergence of financial instability in the 1980s."

Yep, you got it - the entire monetary policy today is based on the ideas tracing back to the 1930s and anchored in the experience that is only partially replicated today. In effect, we are fighting a new disease with false ancient prescriptions for an entirely different disease.

To assess the link between debt and deflation effects on growth, the authors take two measures into account:

• "One is simply its corresponding debt ratio to GDP." 
• "The other is a measure of “excess debt”, which should, in principle, be more relevant. We use the deviation of credit from its long-term trend, or the “credit gap” – a variable that in previous work has proved quite useful in signalling future financial distress."

Per authors, "The results point to little evidence in support of the debt deflation hypothesis, and suggest a more damaging interaction of debt with asset prices, especially property prices. Focusing on the cumulative growth performance over five year horizons for simplicity, there is no case where the interaction between the goods and services price peaks and debt is significantly negative. By contrast, we find signs that debt makes property price deflations more costly, at least when interacted with the credit gap measure."

So deflation in asset prices (property bust) is bad when household debt is high. Why?

Per study: "…these results suggest that high debt or a period of excessive debt growth has so far not increased in a visible way the costs of goods and services price deflations. Instead, it seems to have added to the strains that property price deflations in particular impose on balance sheets. …Why could the interaction of debt with asset prices matter and that with goods and services prices not matter, or at least less so? A possible explanation has to do with the size and nature of the corresponding wealth effects. For realistic scenarios, the size of the net wealth losses from asset price deflations can be much larger. Consider, for instance, the 2008 crisis in the United States,... the corresponding losses amounted to roughly $9.1 trillion and $11.3 trillion, respectively. By contrast, a hypothetical deflation of, say, 1% per year over three years would imply an increase in the real value of public and private debt of roughly $1.1 trillion (about $0.4 trillion for households and roughly $0.35 trillion each for the non-financial corporate and public sector). Moreover, the nature of the losses is quite different in the two cases. Asset price deflations represent declines in (at least perceived) aggregate net wealth; by contrast, declines in goods and services prices are mainly re-distributional. For instance, in the case of the public sector, the higher debt burden reflects the increase in the real purchasing power of debt holders."

And herein rests a major omission in the study: following asset (property) busts, accommodative monetary policy leads to a reduced cost of debt servicing for households that suffer simultaneous collapse in their nominal incomes and in their net wealth. This accommodation is deflating the cost of debt being carried. If it is accompanied by goods and services price deflation, such deflation is also boosting purchasing power of reduced nominal incomes. In simple terms, there is virtuous cycle emerging: debt servicing deflation reinforces real incomes support from goods and services deflation.

Now, reverse the two: raise rates and simultaneously hike consumer prices. what do you get?

1. Debt servicing costs rise, disposable income left for consumption and investment falls;
2. Inflation in goods and services reduces purchasing power of the already diminished income.

Any idea how this scenario (being pursued by the likes of the ECB) going to help the economy? I have none.

26/12/2014: Household Leveraging and Deleveraging in the U.S.

Household debt deleveraging is one of the key forces currently still working through the Western economies, suppressing investment and spending, and supporting precautionary savings. The U.S., having entered the Great Recession ahead of many other economies, armed with stronger consumer-centric systems of insolvency and personal bankruptcy, and having exited the Great Recession with more robust rates of economic growth than other advanced economies, presents a good example or a case study for this process.

One recent paper, by Justiniano, Alejandro and Primiceri, Giorgio E. and Tambalotti, Andrea, titled "Household Leveraging and Deleveraging" (see FRB of New York Staff Report No. 602: http://ssrn.com/abstract=2229366) does exactly that.

Per authors, "U.S. households' debt skyrocketed between 2000 and 2007, but has since been falling. This leveraging and deleveraging cycle cannot be accounted for by the liberalization and subsequent tightening of mortgage credit standards that occurred during the period." Quite strikingly, the authors show that financial liberalisation does not fully explain the cycle.

Instead, "…the credit cycle is more likely due to factors that impacted house prices more directly, thus affecting the availability of credit through a collateral channel. In either case, the macroeconomic consequences of leveraging and deleveraging are relatively minor because the responses of borrowers and lenders roughly wash out in the aggregate."

Of course, the only reasons for this conclusion are the factors mentioned above: the U.S. personal insolvency and debt resolution regimes are far more benign, allowing for a more orderly and less disruptive 'washing out' of adverse effects of household debt overhang.

27/9/2014: Growth... just not in Irish deposits...

Here's an interesting question: when economy grows, what happens with the household deposits? The right answer is: it depends on a couple of factors:

1. How long has economy been growing: if we have growth over a month or two, one can safely assume that households are using up cash to cover their short term debts accumulated over the course of the downturn. Indeed, Irish debts have been shrinking, not growing over the downturn - on aggregate - and growth has been ongoing for a long time now, at least in official accounts.
2. What type of growth we are seeing: if economy grows outside the household sector, e.g. via corporate profits that do not 'trickle down' into the real economy in higher wages, etc, then deposits will not follow growth, although this effect too should be short-lived.

So what happened so far with irish households? Here's a chart:

Since Q1 2011, when the current Government came to office and promptly declared yet another economic turnaround miracle, Irish household deposits are down EUR2.08 billion or 2.23%. Worse, household deposits have been running at a flat trend since mid-2011. 

Total private sector (excluding financial firms) deposits are currently only EUR1.289 billion ahead of Q1 2011 average - a miserly increase of just 1.13%. Given Irish firms and households are still pretty much abstaining from investing in the economy, this shows the current recovery to be almost entirely concentrated in the sectors that ship profits out of Ireland with the balance of domestic growth being fully consumed by the debt servicing and repayments. 

Ah, and do note that any talk about 'rising deposits' in Irish banks that we occasionally hear from our politicians is down to one thing: inclusion of the credit unions' deposits into Central Bank statistics. As shown above, absent that, deposits still remain near crisis-period lows: household deposits today are only 1.1% above their crisis period lows, while non-financial corporates deposits are 1.22% above their crisis period lows. And as of July 2014, Irish household deposits fell in 3 months in a row. Just as growth 'accelerated'. 

13/7/2014: Household Debt Mountains

In the earlier post (here) I covered IMF data on Non-Financial Corporations debt, comparing Spain and other 'peripherals' with Ireland. And here is one other comparative: for household debt

I know, I know... it doesn't matter, really, that households are being tasked with funding Government debt first, their own debt later. All is sustainable...

One caveat: per my understanding, the above does not include household debts transferred to investment funds, as data for Ireland comes from ECB, which does not include data not covered by the CBofI, which does not include household mortgages and other debt sold to institutions not covered by the banking licenses in Ireland. So there, keep raising taxes and reporting higher revenues as a 'success' or 'recovery'... because household debt does not matter... until it matters...

18/6/2014: IMF analysis of Irish households' balance sheet

In previous two posts (here and here) I looked at the IMF's assessment of Irish banks. Now, lets take a quick look at the state of Irish households' balance sheets… Note: I covered outstanding credit to Irish households here.

Again, per IMF: "Household savings remain elevated, with three-quarters of savings devoted to debt reduction since 2010." Which practically means that savings and investment are now decoupled completely: we 'save' loads, we 'save' primarily to pay down debts. We, subsequently, invest nearly nada.

And savings rate has declined: in last 4 quarters on record below 10%, back toward the levels last seen at the end of 2008. Which should mean that consumption should be rising (as savings down)? Not really. Burden of debt is trending down still, from 2012 local peak, but this is still not enough to trigger increased consumption. Hence, the only conclusion is that savings down + consumption flat = income down. Might ask Minister Noon if his policies on indirect taxation have anything to do with this…

More ominously, for all this repayment of debts reflected in our 'savings' rates, the debt pile is not declining significantly:

What is going on? Especially since the recent 18 months should have registered significant debt reductions due to insolvencies and mortgages arrears resolutions acceleration? Ah, of course, that is what is driving the aggregate debt figures (although in many cases the debts are actually rising due to mortgages arrears resolutions, plus sales of debt to agencies outside the cover of Irish Central Bank, like IBRC mortgages sales).

Plus, for all the talk about mortgages arrears resolutions, the problem is barely being tackled when it comes to actual figures:

Oh, and the banks are continuing to squeeze depositors and fleece borrowers:

It's Happy Hour in the banking rip-off (sorry, CBI, profit margins rebuilding) saloon... All along, households are still under immense pressure on the side of their debt overhang.


Next Post: Economic Forecasts from the IMF

10/6/2014: Credit to Irish Households: Q1 2014

Having recently posted miraculous recovery in terms of yet another quarter of declines in lending to Irish private sector enterprise (see: http://trueeconomics.blogspot.ie/2014/06/662014-credit-to-irish-resident.html) repaired/restored/reformed Irish banking system coughed out another set of 'encouraging' data points… today's one coming on the side of credit advanced to Irish private [assuming this excludes Irish public - aka celebrity economists et al] households. And guess what… the aforementioned repaired/restored/reformed Irish banking system is shrinking in terms of household credit too, still…

Chart to start with:

And the above shows:

• Total credit extended to Irish households falling 2.62% in Q1 2014 compared to Q1 2014 and down 0.54% q/q
• Credit advanced for house purchases is down 1.21% y/y and basically flat (-0.03%) q/q.
• SVR mortgages volumes are up (arrears restructuring and new mortgages extended adding to the pile of soon-to-be even more expensive loans, as the banks re-engage in margins rebuilding post-ECB rate cut); Trackers are down; Up to one year fixed rates mortgages are up, Fixed rate mortgages are down;
• Other personal loans are down whooping 9.98% y/y and are down 5.82% q/q (with both Finance for investment and Finance for other purposes sub-categories down by more than 5% q/q).

Meanwhile, deposits (remember our 'gargantuan' savings rates that worry everyone from ESRI to DofF) well… deposits are down 1.78% y/y and down 0.14% q/q.

Remember our Government's talk about repairing the banking system? One of the core metrics for this was loans/deposit ratio. Chart below shows evolution of this:

Observe one interesting regularity: since Q4 2011, loans-deposit ration in terms of Irish households' balance sheets averaged 114.7% and in Q1 2014 this ratio was… err… 114.2%. In other words, things have not been improving when it comes to loans/deposit ratio for some 10 consecutive quarters now…

Since we are onto the topic of 2011, recall that in H1 2011 we have recapitalized Irish banks, which, ever since that time, been on a steady path of recovery. Even Wilbur Ross says as much, let alone our Ministers and Senior Officials. Numbers confirm… the opposite story: compared to H1 2011, q1 2014 levels of households' credit in the economy was down massive 18.2%, credit for house purchase down massive 15.5%, credit for other purposes down gargantuan [truly] 30.9%, while deposits are down 1.82%.

Clearly things have to be looking sunnier some day soon... of Wilbur will have to come back to help us repair the banking system once again...

9/5/2014: Irish Credit Conditions Worsened in Q1 2014

Latest data on interest rates (covered here: http://trueeconomics.blogspot.ie/2014/05/952014-cost-of-credit-in-ireland-kept.html) and credit outstanding in the Irish banking system shows continued deleveraging in the economy:

At the end of Q1 2014,
-  Total volume of loans outstanding declined 5.6% y/y,
-  Loans to Households were down 1.54% y/y and
-  Loans to NFCs were down 9.29%.
-  Loans for house purchases were down EUR1.46bn,
-  Households' overdrafts rose EUR1.39bn, while
-  Consumer credit loans were down EUR1.43bn.
-  NFCs overdrafts fell EUR2.81bn and
-  Non-overdraft NFCs credit fell EUR5.2bn.

So credit available to enterprises and households in Ireland is still falling. More significantly, households are accumulating overdraft liabilities. And the cost of these facilities is rising.

Not a good sign, suggesting households and corporates are being squeezed on both ends of the debt deflation pump.

3/4/2014: Draghi's Put and Ireland's Woes

This is an unedited version of my Sunday Times article from March 16, 2014


To those who lived through the tropical storms annually ravaging the Southern Atlantic coast of the US, calm is not always the tranquility beyond the storm. Often, it is the tranquility in the eye of a hurricane.

The current state of economic affairs in Ireland, the sunshine washing across the markets, the warm-ish glow of a recovery, the steady diminishment of the crisis rhetoric - all are the sign of a fragile state of affairs brought about by the extraordinary monetary policies of the ECB since the beginning of 2012. As such, the change in economic weather we have experienced to-date can be a temporary respite rather than a permanent rebound.

In October 2012, three months after declaring that the ECB will do whatever it takes to save the euro, Mario Draghi noted another worrying regularity - the problem of differential pricing of debt across the euro area. At first, he was referencing government debt markets. Later, he started to show concern for the same trends emerging in all credit markets, including those for corporate debt.

Ever since then, the ECB has signalled that the Central Bank's core policy in dealing with the crisis will remain accommodative. Historically low policy rates, the promises of the Outright Monetary Transactions and the structuring of the Banking Union – together constituting what is known as the Draghi Put – were the Frankfurt's attempts to break down the fragmentation across various euro area economies. These measures were successful in reducing the differences in sovereign bonds yields between the euro area member states. First Ireland, Italy and Spain, then Portugal and Greece, all peripheral countries have seen their bond spreads over the German benchmark 10 year bunds come down dramatically in the course of the last 20 months.

Since mid-2012, therefore, the Draghi 'Put' underwrote historically low policy rates. It is this 'Put' that has been credited by the researchers at the ECB and the IMF, as well as by a number of academics, as the main driver behind the decline in euro area peripheral countries cost of borrowing, saving Irish taxpayers billions in interest on Government debt, helping hundreds of thousands of Irish borrowers to lower tracker mortgages costs and supporting our exit from the Troika programme.

But, in effect, the Draghi Put has also thrown a veil of ignorance over the core problems still working through the euro area economies: problems of excessive legacy debts, lack of structural drivers for the recovery and the transfer of public and banking debts onto the households' balance sheets through fiscal austerity. ‘Whatever it takes' monetary policies might have been effective in alleviating the immediate pressures on European governments, but they did not cure the underlying disease.


In effect, the Draghi Put is not a solution to the crisis, but a potential problem of its own. It is a cure that is risking making the disease stronger.

Draghi Put has forced ECB rates (and with them the rates charged in the inter-banks markets) down to their historical lows.

Current repo rate, the main rate set by the ECB, is at 0.25 percent - the lowest since the ECB records began in January 1999. Over the period prior to the crisis, the already low (by individual nations' standards) ECB rates averaged 3.1 percent. And the duration of the ECB rates deviation from their historical norm is unprecedented: 62 months and counting. Prior to the current crisis, the longest period over which ECB rates deviated by more than 0.5 percent from their norm was 38 months. That happened in the period that created a massive financial bubble across the euro area – January 2003 through June 2006.

In general, the longer the rates rest below their long-term trend, and the further they deviate from the trend, the faster they tend to rise back toward trend levels. Exception to this norm is Japan, but hardly anyone would argue that Japanese scenario is even remotely desirable.

In simple terms, the current environment of historically low interest rates is not going to last forever. Indeed, it is unlikely to last for as long as the rates have been depressed to-date.

Alongside the above facts, there two more notable observations worth making. Darghi Put has led to a significant decline in the inter-bank lending rates. For example, Euribor 12 months contract rate has declined from the crisis-period average of 2.1 percent for the period prior to the Draghi Put to the average of 0.6 percent since July 2012. Similarly, there was a massive decline in the margin charged in the interbank markets relative to the ECB repo rate. At the same time, retail interest rates charged on new loans for Irish households and non-financial corporations have shut straight up to historical highs, when compared against the ECB policy rates. Ditto for the rates charged on existent loans.


All of this leaves our economy vulnerable to any normalisation in the interest rates policy.

Should Signore Draghi start reversing the policy rate, while Irish banks remain dependent on high lending margins to rebuild their balance sheets, Irish SMEs will face significant increase on the cost of financing their legacy loans, including the very same troubled loans that relate to property investments. Beyond triggering potential arrears and cost saving measures by the SMEs (involving layoffs), this will put strain on any growth in the SMEs sector. Capital investment costs will go up. Credit risk ratings will go down. Investment in the economy will be under severe pressure relative to the already exceptionally low rates.

Households currently working their way through arrears resolution process are likely to face high risk of relapsing into arrears. To-date, some three quarters of all restructuring deals done by the banks involve either temporary arrangements or ‘permanent’ deals that involve increases in debt carried by the households. They will face increases in the cost of restructured mortgages, impacting not only those on variable rate (the segment of the mortgage holders already heavily hit by the banks), but also trackers. Depending on how fast and at what time in the recovery process rates increases occur, the effect can be devastating. Households that are not in trouble with their lenders today will face a major hit on their incomes, depressing once again their consumption and investment and triggering a renewed bout of precautionary savings.

Counting existent loans alone, reversion to historical averages in ECB rates can take some EUR5.7 billion annually out of the real economy in higher interest costs. This would be roughly equivalent to a loss of double the annual contribution to our GDP by the Agriculture, Forestry and Fishing sector.

The above factors can also pose a threat to the Exchequer in form of lower VAT, income tax, stamps and excise receipts, exacerbated by the potential increase in the cost of borrowing that goes hand-in-hand with higher policy rates.


The good news is that given Mr Draghi's current pronouncements, we are still months, or even years, away from higher interest rates. Better news, yet, Mr Draghi has communicated that he will provide 'forward guidance' on rates policy. This commits the ECB to supplying in advance clear signals as to its intentions. Even better news is that last week Mario Draghi clearly identified output gap (the shortfall in current economic growth relative to long-term potential rates of growth) as one of the parameters watched by the ECB. This strongly suggests that Frankfurt is likely to take into consideration structurally weak economic conditions prevailing across the euro area in setting its policy rates. Such a consideration further extends the period over which low rates are likely to remain in place.

The bad news is that the only way the rates can remain low is if the euro area core remains mired in a near-deflationary Japanese economic growth scenario.

In other words, we have a choice: either the economy remains in the doldrums, unemployment stays high and incomes growth remains subdued; or the rates will go up.

Mr. Draghi Put is not based on the smaller peripheral economies conditions, but on France, Italy, Spain, Belgium, Finland and Austria as drivers of credit demand and low interest rates, and Germany as a break on low interest rates. Meanwhile, German lending constraints for non-financial companies have been at record lows for months now. There is a glut of credit in the euro area's largest economy. Thus, Germany will be ripe for rates hikes, as soon as inflation pressure picks up even moderately. The countries with shortages of credit supply are seeing their economies gradually pulling out of a recession. One can relatively safely assume that, barring new shocks, by the end of 2015 the ECB will start contemplating the end of Mr Draghi's Put.

Put conservatively, anyone with business loans or mortgages of duration greater than 5 years should be concerned. By last Central Bank of Ireland count, these loans amounted to 65 percent of all loans outstanding in the economy.


There is little we, in Ireland, can do about the direction of the ECB interest rates or the timing and the speed at which the rates increases will happen. About the only two things in our power are to ensure that current process of restructuring of SMEs loans and household mortgages is robust enough to withstand the shock of higher interest rates in the future, and that our households incomes retain the necessary cushion to absorb such increases. The former requires much more through and independently verified restructuring of our legacy debts. The latter requires lower tax burden, deep reforms and faster economic growth anchored in our real economy, not in the tax optimising MNCs-led sectors.

Absent these measures, Irish economy is a weak athlete swimming into a storm surge. The eye of the hurricane might make us feel better about our perceived strengths, but the clouds on the ECB’s horizon, no matter how distant, warn of a possible storm to come.

Box-out:

ESRI’s latest research paper on the impact of the banking sector competition on credit availability to the SMEs across the EU sheds some light on the urgency for Ireland to abandon the banking sector policy based on the Twin Pillars model.  “Does Bank Market Power Affect SME Financing Constraints?” published in an influential Journal of Banking & Finance argues that banking sector retrenchment across the Eurozone towards domestic markets and reduced competition between the banks “will lead to an increase in financing constraints for SMEs”. Such constraints “will inevitably lead to lower investment and potential output. “ According to authors, “the structure of the banking system has changed dramatically following crisis... This has substantially lessened competition for business credit in Ireland with only three main retail business banks remaining. This reduction in competition poses serious questions regarding the ability of the financial system to transmit credit to SME borrowers in a recovery scenario.” In short, given Irish SMEs’ heavy reliance on bank financing, we need more than a new pillar bank. We need a fully competitive financial system operating across the economy. This will be hard to deliver on. Irish Pillar banks continue to rely on state protection for even trivial market considerations, such as deposits rates setting by their competitors, e.g. An Post. And our regulators and policymakers are still clinging to the erroneous belief that competition in the banking sector in 2001-2007 has fuelled the boom and caused the crisis.

21/10/2013: Household Debt Crisis: Social Drivers

Recent CEPR Discussion Paper No. 9238 (December 2012) titled "Household Debt and Social Interactions" by Dimitris Georgarakos, Michael Haliassos and Giacomo Pasini looked at social determinants and drivers for debt accumulation amongst households.


According to the authors, "Debt-induced crises, including the subprime crisis, are usually attributed exclusively to supply-side factors. We examine the role of social influences on debt culture, emanating from perceived average income of peers. Utilizing unique information from a household survey, representative of the Dutch population, that circumvents the issue of defining the social circle, we consider collateralized, consumer, and informal loans. We find robust social effects on borrowing - especially among those who consider themselves poorer than their peers - and on indebtedness, suggesting a link to financial distress. We employ a number of approaches to rule out spurious associations and to handle correlated effects."

More specifically, the authors find that "the higher the perceived income of the social circle is, the greater is the tendency of respondents to take up loans and borrow sizeable amounts. This is true both for uncollateralized (consumer) loans and for collateralized loans…"

The above effect is "stronger for those who perceive themselves as having lower income than their social circle." In effect, this is keeping up with the Joneses effect, magnified by within-reference group peer effects.

"The tendency of households to take up uncollateralized and collateralized loans, controlling for the perceived average income of the social circle, is partly related to perceived spending ability or (computed) housing assets of members of the social circle."

"Moreover, we find that expectations about (the minimum) next period’s income are statistically significant for collateralized loans, pointing to a ‘Tunnel Effect’, but do not render perceived income of the peers insignificant. This is consistent with the idea that borrowing behavior is influenced by peer income not only because it conveys some information regarding the respondent’s own future, but also because of some comparison or envy effect." Notice - this is about basic human psychology, as co-determined by external (not internal or own-control) factors. In other words, any corrective policy will have to address the issue of peer effects, not only 'own effects'.

"Finally, the role of such comparisons is not confined to the tendency to borrow and to the level of borrowing conditional on participation, but it seems to extend also to financial distress."

To reinforce the argument above that the drivers of borrowing crises are social, not just individual (and hence any responsibility, liability and policy actions on this front have to be co-shared): "Our study has uncovered a potential for social influences on borrowing. By observing that others have higher average incomes, the household not only tries to emulate their
spending, as earlier studies have found, but also decides to borrow more, only partly because of expectations of higher future own income. Such decisions may be encouraged by a massive and unprecedented housing boom associated with high collateral values and expectations of continuing house price trends. The policy implication of our finding that social comparisons matter for debt behavior, after controlling for fundamental characteristics
of the household and region-time trends, is not to interfere with the process of forming social circles or perceptions regarding them, but rather to decouple perceptions of income or spending differences with peers from any decisions to borrow without proper account of the associated risks."

My view: let's cut puritanism bull**&t and recognise that debt crises are not solely driven/caused by the reckless behaviour of individuals taken in an isolated setting, but are social / societal phenomena. This realisation should lead us to a recognition that dealing with prevention of future crises and with the fallouts from the current ones requires co-shared responsibility and liability.


Source: for earlier version (free to download) http://arno.uvt.nl/show.cgi?fid=127996

19/10/2013: Debt Bias and Wealth Taxes: Pesky IMF Ideas...

Nasty little bit from the IMF Fiscal Monitor - a box-out on page 49 of the report...

So the IMF basically reminds us that once things get desperate, wealth taxes (err... Irish pensions levy anyone?) or put differently - expropriation of private wealth - can be contemplated...

Reinhart and Rogoff have warned us all about the Financial Repression coming, so no surprise here. What is, however, surprising is the IMF estimate at the end of the box-out. "The tax rates needed to bring public debt to precrisis levels... are sizeable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) a tax rate of about 10 percent of households with positive net wealth".

Give it a thought - 10 percent on average for the euro area... for Ireland? 20%? 30%?.. And, of course, what will that do to households' debt?.. oh, wait, that does not matter in Europe...


Oh, and while on the topic of debt. I wrote recently (here) about the issue of 'debt bias' (incentives to hold debt over equity) in tax systems... Here's a chart from the same report (page 45) showing the impact of eliminating 'debt bias' in tax system on systemic stability of the country financial system:

Of course, Irish policymakers are keen to eliminate the bias - not because it can help repair the systemic instability of our financial system, but because eliminating the bias will increase state yields from debt-funded property loans (via closing of the mortgages interest relief).

Once again, the problem is that of legacy - what do such closures of 'debt bias' do to sustainability of mortgages debt already carried in the system? Once again, no one pays any attention to the issue...

21/6/2013: Most Important Charts in the World, June 2013

Business Insider produced another set of charts, under the usual heading of "Most Important Charts in the World": http://www.businessinsider.com/most-important-charts-in-the-world-2013-6#

Obviously (shameless self-promotion alert) number 22 worth a look...
http://www.businessinsider.com/most-important-charts-in-the-world-2013-6#constantin-gurdgiev-trinity-college-dublin-its-going-to-take-a-long-time-to-pay-off-eurozone-debts-22

Here it is reproduced from my file:

You can click on the image to enlarge.

Note, the same relationship exists for Government debt or Household debt taken alone and the individual relationships are actually even stronger (adjR2 in the range of 43-44% against 38% for the combined debt relationship).

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

24/4/2013: Credit demand conditions in Irish banks: Q2 2013

All's quiet in the Irish Banking 'sector' Zombieland, per CBofI latest missive (link):

Good news: there was an improved demand for Fixed Investment in Q4 2012. Since then, Q1-Q2 2013 shows zero growth in demand. Non-news: Operating capital is now again tight (Q4 2012 and Q2 2013) against zero change in Q1 2013. Bad news: restructuring demand is up again after posting zero growth in Q1 2013.

So on business credit demand side: no real economic activity growth is signalled by investment demand, poorer conditions in operating capital signalled by the respective demand increase (albeit very moderate rate of increase) and credit restructuring pressures are slightly up as well.

On households side:

House purchases credit demand is up, at weak and moderating rate. Nothing dramatic, really, but good-ish sort of news. 

Basically, things are flat. Again, you can read this as a somewhat positive (things are not getting worse), or you can treat it as somewhat negative (given rates of contraction in credit during the crisis, real recovery should see demand and supply spiking rapidly up). My view is - the above confirms the proposition that Irish economy is at near-zero real growth trendline and the banking sector remains a drag on growth.

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.

15/11/2012: Dutch Debt Crisis and a Tripple-dip Recession?

With Eurostat publishing today preliminary estimates for Euro area GDP for Q3 2012, the Netherlands have moved firmly into the view as the country with substantial pressure on its economy.

Take a look at the core numbers:

• In Q3 2012, the Dutch economy contracted 1.1% q/q - the sharpest quarterly contraction in all fo the EU27
• This contraction follows 0.1% growth in Q2 and Q1 2012 and a contraction of 0.7% in Q4 2011
• In other words, in q/q terms, the Netherlands are now heading for a tripple-dip recession.
• In year on year terms, things are bleaker still: Q4 2011 say annual contraction of 0.4%, which was followed by a 1.0% drop in Q1 2012, 0.4% decline in Q2 2012 and now 1.4% decline in Q3 2012.

The problem the country faces, despite having a AAA-rated government debt and relatively minor issues on the fiscal side, is the debt overhang in the household sector. As charts below show, the Netherlands has the second highest gross debt/GDP ratio in the EU27 and the highest in the euro area. The debt overhang in the household sector is getting worse, not better, during the current crisis.

Gross debt to GDP ratio on households side has the same (directionally, but potentially more severe in magnitude) effect on future growth as the Government debt. Based on the OECD and IMF data:

And here are some comparatives from Goldman Sachs Research, highlighting the Netherlands plight:

 Note: HP change refers to House Prices change

All of which makes the Netherlands a 'sick man' of Europe and helps explain why the Dutch Government is rightly concerned with the costs of underwriting peripheral economies 'rescue' using its own money...

30/7/2012: Euro Area forecast by Standard and Poor

S&P's note on euro area crisis is a rather entertaining read, if you are into the sort of 'entertaining' a la mode of Quentin Tarantino... The note is The Curse Of The Three Ds: Triple Deleveraging Drags Europe Deeper Into Recession, authored by EMEA Chief Economist: Jean-Michel Six.


Snapshot of views (emphasis mine):

• A combination of public, household, and bank deleveraging are stifling growth in most European economies. [Now, I've been saying all along that we cannot ignore household debts, yes so far, European and National policymakers are utterly hell-bent on saddling indebted households with the bills for indebted states and banks. Just look at Ireland, where the banking sector is now outright moving into enslaving households by dictating to them how much they should spend on food & clothing so they can maximize extraction of mortgages repayments. And the Irish Government only eager to lend their support to the banks.]
• This is also limiting the effectiveness of the European Central Bank's efforts to support the financial sector and eurozone economies. [Not really, folks. You might missed it, but European 'leaders' are heavily taxing economy already to subsidize insolvent banks and sovereigns. Alas, the room for more taxes is limited in Europe not by household debt - about which the respective National Governments give no damn - but by the fact that Europe already has some of the highest income taxes in the world.]
• Subsequently, the S&P is cutting their base-case growth forecasts for the eurozone and U.K. economies for 2012 and 2013. See two tables below

• S&P also see a 40% chance that downside risks could push European economies into a genuine double-dip recession in 2013 (second table above).

So risk-weighted expected growth is now forecast, for the Euro area to be -0.76 in 2012 and -0.08 in 2013. If we take potential growth at 1.5%, this would imply an opportunity cost of over 3% in 2012-2013 to the Euro area economy.

And the core downside risks are:

• A hard landing in some emerging markets, delaying the recovery in world trade;
• The prospect of one of the main eurozone countries losing access to capital markets for a prolonged period; and
• A more pronounced retrenchment in consumer demand, especially in the core countries.

Key changes to previous forecasts:

• "We have cut our forecast for GDP growth in France to just 0.3% this year and 0.7% in 2013, from 0.5% and 1%, respectively, in our previous forecasts. 
• "We've also revised downward our GDP projections for Italy to negative 2.1% for 2012 and negative 0.4% in 2013. 
• "In the case of Spain, we now forecast GDP will decline by 1.7% this year and that it will be negative 0.6% next year—a cut from our previous forecast declines of 1.5% and 0.5%. 
• "For the U.K., we have revised our 2012 estimate to 0.3% this year. Yet, the provisional GDP estimate released on July 25 by the U.K. statistical office for the second quarter of negative 0.7% makes our full-year forecast more uncertain. If confirmed, this result would most likely lead to zero or slightly negative growth this year."

22/6/2012: Deleveraging of Households US v UK, Spain

An interesting chart from McKinsey today updating deleveraging process for household debt in the US, Spain, and the UK:

Nothing new here (I have been saying the US is ahead of Europe on deleveraging, if only due to speedier foreclosure actions - which are slowing down due to legal challenges etc). And, unfortunately, the chart is very limited as to the scope of countries represented... but it does show how unrealistic are Spanish current expectations when it comes to how much more debt repayment would have to be generated to even get close to a more benign debt crisis in Sweden in the 1990s.