Economics 15/06/2010: Negative equity 3

Here is the third and last post in the series on negative equity based on my TCD speech (see here).

Rising negative equity has implications for financial stability:

Domestic mortgage lending by the major banks represents over x5 times their core Tier 1 capital in the UK and roughly 10 times in Ireland. Even post disposal of its assets (assuming rosy valuations), AIB’s multiple will be over x11 of its risk-weighted assets. BofI – x7-8. And these are the better ones of the Irish banking lot. In addition, around 40% of all outstanding UK mortgage debt has been used to back securities.

Large losses on these mortgage loans and associated securities can erode banks’ capital positions, affecting both lenders’ willingness and ability to lend and, in extreme cases, their solvency.

Both of the above effects can have implications for aggregate demand and the supply capacity of the economy, highlighting the interdependency of financial stability and monetary policy. Again, in the case of Ireland, the two effects are reinforced by the large exposure of the Exchequer to banks balancesheets and to the property markets.

The defining feature of the materialised losses, and their associated economic effects, is the value of debt at risk (loss given default) and the coincidence of that with the probability of default.

Rising negative equity has implications for loans default probabilities:

In economic literature, negative equity is a necessary condition for default to occur since borrowers with positive equity can sell their house and use part of the proceeds to pay off their mortgage. Transaction costs (high in Ireland) and transaction lags (also extremely long in Ireland) act to further increase this effect. For example, a household with positive equity of ca 10% will still trigger a partial default on the mortgage if it takes a year to close the sale (8% funding opportunity cost per annum) and if closing costs add up to 2% of the sale price.

However, negative equity is not a sufficient condition for default to occur, as discussed in “Negative Equity and Foreclosure: Theory and Evidence” by C. Foote, K. Gerardi and P. Willen (June 05, 2008, FRB Boston Policy Discussion Paper No 08-03). Similarly, in the UK, May and Tudela (2005) find no evidence that negative equity increased the likelihood of a household experiencing mortgage payments problems between 1994 and 2002, although their sample does extend over a lengthy period of robust economic growth and rising incomes. The latter two aspects of the sample are not present in today’s Ireland.

But, as Heldebrandt, Kawar and Waldron (2009) highlight, “if a household is experiencing difficulties meeting their mortgage payments, negative equity can increase the probability of default by reducing the household’s ability to make payments by preventing equity withdrawals.” Benito (2007) found that households are more likely to withdraw equity from their homes if they have experienced a financial shock. Negative equity can affect a household’s ability to do that because of credit constraints.

Furthermore, negative equity can increase the probability of default by reducing household’s willingness to make mortgage payments, since defaulting can reduce the debt burden of the household. In Ireland, despite our anachronistic bankruptcy laws, this option is still available for anyone willing to emigrate. You might as well call this www.book-your-one-way-ticket.ie effect, as households leaving Ireland fleeing bankruptcy will have:

1. a very strong incentive to emigrate; and
2. a very strong incentive never to return for the fear of debt jail.

Negative equity may significantly increase the probability of default of buy-to-let mortgages over and above that of owner-occupiers as costs of defaulting on a buy-to-let mortgage may be lower because defaulting does not lead to loss of residence. In addition, buy-to-let mortgages are, at least in some cases, registered via businesses, implying no recourse on family homes and wealth.

Overall, available economic evidence does suggest that negative equity plays a significant role in mortgage defaults:

• Coles (1992) presents results from a 1991 survey of lenders in which a high LTV ratio was frequently noted as an important characteristic of borrowers falling behind in meeting their mortgage payments.
• Brookes, Dicks & Pradhan (1994) and Whitley, Windram & Cox (2004) find that a reduction in the aggregate housing equity in the UK was associated with an increase in arrears.

Overall, Heldebrandt, Kawar and Waldron (2009) conclude that “evidence suggests that the level of household defaults, and the impact of negative equity on financial stability, is likely to depend on conditions in the broader macroeconomic environment”. And Ireland is at a clear disadvantage since the combined macroeconomic shocks (decline in GDP/GNP, rising unemployment and contraction in private sector credit) are much more severe here.

Rising negative equity has implications for the size of the expected banks losses:

When bank borrowers face negative equity, as probability of default and the value-at-risk in default rise, banks have an incentive to stave off the actual mortgage default. To do this, banks engage in:

• Renegotiations of covenants (loans extension, provision of a grace period, interest only repayments etc)
• In extreme cases – joint equity ownership in asset (though banks will usually engage in this type of transactions under regulatory duress)
  

All of these measures aim to put the borrower into a position to eventually repay the loan in full.

However, in cases where default in unavoidable, the loss to be realised by the bank on any given loan depends on the recovery that can be achieved if the borrower defaults. Negative equity, or positive equity that does not exceed the sum of the cost of carrying the loan during the sale, plus the cost of sale, will imply a net loss on the default. From the bank point of view, the problem is not in the actual level of individual defaults, but in the combined level (aggregate) of negative equity net of costs and recovery values.

Such net losses impact not only the actual mortgage book, but also securitised pools that can be held off balance sheet, as current negative equity puts at risk future revenue against which the book is securitised. The end result on mortgage backed securities side is to reduce the value of MBS asset and, as Heldebrandt, Kawar and Waldron (2009) point out this can induce a second order effect of changing risk perceptions and investors’ sentiment “regardless of the actual performance of any given portfolio of loans”.

Both types of losses lead the banks to record write downs on their mortgage books and securities held. If these are large enough, banks’ capital ratios will be reduced.

In the case of Ireland the problem is compounded as the banks are actively delaying recognition of losses on negative equity. These delays mean that banks are likely to pay elevated costs of external funding over longer period of time. In addition, these delays lead to losses compression – the situation where banks recognize significantly larger volumes of impaired assets later in the crisis cycle. Bunching together losses creates a much more dramatic investors’ loss of confidence in the bank.

In addition, negative equity-driven impairments, plus delayed recognition of such impairments lead to suboptimally high demand for capital from the banks. If this coincides with the period of severe credit crunch, monetary policy aimed at increasing economy-wide liquidity flows can become ineffective, as banks park added liquidity on their balance sheets, creating a liquidity trap. This is evident throughout the crisis, but by all possible monetary policy metrics, it is much more prevalent in Ireland, where even today credit available to the private sector continues to contract. Irish banks are hoarding liquidity and are raising lending margins to offset expected, but undisclosed writedowns. This problem is compounded by Nama which induces greater uncertainty onto banks balance sheets through its hardly transparent or timely operations.

Negative equity and generational asset gap:

In Ireland, the problem of negative equity is further compounded by the generational spread of negative equity to predominantly younger, more productive and more mobile (absent negative equity) households. These households today face higher probability of unemployment (thanks to our unions-instituted and supported ‘last in – first out’ labour market policies). They also much deeper extent of the negative equity because of higher cost of financing their original mortgages and entering the housing market.

The generational effects of negative equity are compounded by geographic distribution of the phenomena – with younger households being more likely to reside in the areas of excess supply of new housing, with poor access to alternate jobs, should they experience unemployment.

Finally, it is the younger households that are subject to twin effects of higher probability (and deeper extent) of negative equity and depleted savings (due to high cost of entry into the housing market). This implies that it is the very same households which have the greatest incentive to engage in precautionary savings motive.


So traditionally, economies grow by:

• encouraging the young to acquire new assets (invest and save); and
• encouraging the old to consume (divest out of savings).

With negative equity, Nama and pressured banks margins, Ireland is:

• forcing the better (more productive today and in the future) young to emigrate;
• keeping the remaining young deep in the negative equity (neither capable of investing in the future, nor of moving to find a lost job today);
• underwriting - at the expense of younger, tax paying generations - continued excessive provision of pensions to retired public sector workers;
  
• forcing younger families to cut deeper and deeper into their children education budgets and own training and education funds in order to assure they continue paying on the asset that will never have net positive return on investment; and
• incentivising the old to remain in their highly priced (if only rapidly losing value) homes backed by slacked consumption due to inability to monetize their pensions savings.

In what economics book is this scenario better than any moral hazard problem that can be incurred in the short run by reforming our bankruptcy system to an American-styled 'restart' button?

Economics 15/06/2010: Negative equity 2

This is the second post of three consecutive posts on the effects of negative equity in Ireland.

Negative equity can lead to a reduction in consumer spending, collateral & credit

This can take place via four main pathways:

1. Housing equity can be used as collateral to obtain a secured loan on more favourable terms than a loan which is unsecured. This channel for lower cost financing is cancelled out by the negative equity.
2. Falling collateral values may also affect the cost of servicing existing mortgages if borrowers have to refinance at higher interest rates when their existing deals expire (eg when exiting temporarily fixed-rate or tracker mortgages). That would reduce income available for consumption, which may further reduce demand.
3. Households on adjustable rate mortgages are facing additional pressure of higher banks margins. Since vintages of many ARMs are coincident with 2005-2007 period, negative equity has direct and significant impact on them. Nama exacerbates this impact by forcing banks to up their margins on performing loans, pushing more and more households into not just negative equity, but virtual insolvency.
4. Fourth, falling values of housing equity also reduce the resources that homeowners have available to draw on to sustain their spending in the event of an unexpected loss of income (eg due to redundancy, illness or a birth of a child). By reducing the value of housing equity, falling house prices may lead some homeowners to seek to rebuild their balances of precautionary saving at the expense of consumer spending and investment.
   

Note that precautionary savings are held in highly liquid demand deposits – a fact that I will use below. In general, households with high amounts of housing equity may not respond much to falling house prices, because their demand for precautionary savings balances may already be satisfied through their positive net worth balances on the house. Households with low or negative equity have an asymmetrically stronger incentive to save in a form of short-term deposits.

Rising negative equity can also result in a reduced supply of credit to the economy as a whole:

Negative equity can raise the loss that lenders would incur in the event of default (loss given default) and the probability of a loss. That can make banks less willing or able to supply credit to households and firms.

Per Benford and Nier (2007) Basel II regulations, which require banks to hold more capital against existing loans when their anticipated loss given default rises, can reinforce that.

If credit is more costly or difficult to obtain, households and firms are likely to borrow less, leading to lower demand through lower consumer spending and investment. This, in turn, can lead to reduced business investment.

Expectation hypothesis suggests that negative equity effects on willingness to borrow and lend can extend beyond those immediately impacted as other households anticipate their own asset value decline toward negative equity.

Blanchflower and Oswald (1998) paper showed that a reduction in credit availability may also have some effect on the supply capacity of the economy by reducing working capital for smaller businesses and the capital available for small business start-ups. In addition, a recent (June 2009) paper “Reduced entrepreneurship: Household wealth and entrepreneurship: is there a link?” by Silvia Magri, Banca d’Italia, published by the Bank of Italy (Working paper Number 719 - June 2009) shows that negative house equity can result in reduced entrepreneurship, as many new businesses are launched on the back of borrowing secured against primary residencies or other real estate assets.

Rising negative equity can also result in a reduced household mobility:

Negative equity can affect household mobility by discouraging or restricting households from moving house. Two fathers of behavioural economics, Tversky and Kahneman (1991) argued that households may be reluctant to move because they would not wish to realise a loss on their house. Notice, that our so-called ‘smart’ politicians often claim that negative equity is never a problem unless someone wants to move. Actually, it is a problem even if someone does not want to move, but has to move because of their changed employment or family circumstances.

Tatch (2009) shows that a household in negative equity would be unable to move if they were unable to repay their existing mortgage and meet any down payment requirements for a new mortgage on a different house. This is even more pronounced in Ireland due to the nature of Irish bankruptcy laws.

Hanley (1998) shows that the effect of negative equity on mobility were quantitatively significant during the early 1990s in the UK. The paper estimates that of those in negative equity in the early 1990s, twice as many would have moved had they not been in negative equity. The paper argues that reduced household mobility leads to a reduction in the supply capacity of the economy by increasing structural unemployment and reducing productivity.

Reduced household mobility implies a reduction in the number of households moving home. This can have adverse implications for tax receipts, spending on housing market services and certain types of durable goods as highlighted in Benito and Wood (2005). So as negative equity increases, tax revenues and economic activity in the housing sector and associated white goods sectors falls.

15/06/2010: Negative equity 1

Yesterday, I gave a speech at the Infinity Conference in TCD on the issue of negative equity (see newspaper report here). The following three posts (for the reasons of readers' sanity) reproduce the full speech.

What effects can negative equity have in the case of Ireland?

I did a troll of the literature on negative equity and below I summarize the main findings, relating some to the case of Ireland.

Broadly-speaking there are three dimensions through which negative equity can have an effect on Irish economy:

1. Macroeconomic channels via negative equity impact on aggregate supply and demand;
2. Monetary channels which lead to negative equity impacting adversely banks balance sheets and increasing the cost of default and probability of default for mortgage holders; and
3. Growth channels, which relate to the adverse effects of current negative equity on future demand and investment, and directly on growth.

Here are more detailed explanations of these channels.

Why the problem of negative equity is likely to be greater in Ireland than in the UK

A forthcoming paper “House Price Shocks and Household Indebtedness in the United Kingdom” by Richard F. Disney (University of Nottingham), Sarah Bridges (University of Nottingham) and John Gathergood (affiliation unknown), to be published in Economica, Vol. 77, Issue 307, pp. 472-496, July 2010, used UK household panel data to explore the link between changes in house prices and household indebtedness. The study showed that borrowing-constrained by a lack of housing equity households make greater use of higher cost, higher risk unsecured debt (e.g. credit cards or personal loans). Crucially, when house prices revert to growth, “such households are more likely to refinance and to increase their indebtedness relative to unconstrained households”.

These effects – present in the case of the UK – are likely to be more pronounced in the case of Ireland, because Irish households which find themselves in negative equity today experience much severe deterioration in their net worth base due to the following factors:

• Majority of Irish households have been forced to front-load property taxes into their purchase costs and often mortgages. Thus average LTVs are more likely to be higher here in Ireland, for more recent mortgages vintages, than they were in the UK.
• Ireland has experienced a much more severe contraction in house values than the UK to date.
• Because of significantly higher entry-level taxes, younger buyers in Ireland had to be subsidized more heavily by their parents than their UK counterparts, implying that once true levels of indebtedness are factored in, real mortgages and debts held against a given property of more recent purchase vintage might be higher than those recorded on the official mortgage books.
  

In many cases – we do not know how many, but anecdotal evidence suggests quite a few – credit unions and building societies, as well as non-mortgage banks were engaged as sources of top up loans to younger buyers, implying that once again the true extent of house purchase-related debt in Ireland, for younger households, might be higher than official records on mortgages suggest.

Another recent study, titled “The Economics and Estimation of Negative Equity” by Tomas Hellebrandt, Sandhya Kawar and Matt Waldron (all Bank of England) published in Bank of England Quarterly Bulletin 2009 Q2 looked at the effects and extent of negative equity between Autumn of 2007 and the Spring of 2009. Over that period of time, nominal house prices fell by around 20% in the UK, suggesting that negative equity impacted around 7%-11% of UK owner-occupier mortgage holders by the Spring of 2009.

By now, in Ireland:

• house prices fell down ca50% already (accounting for the swings in terms of premium to discount on asking prices – by closer to 55%),
• vintage of many purchases was much closer to the peak valuations, so
  

for Ireland, estimated negative equity impact is now around 35-40% of the mortgage holders.

Extent of negative equity here is compounded by:

1. High entry costs into the homeownership (100+% mortgages due to stamp duty costs and poor quality of real estate stock);
2. Lax lending – cross-lending by banks and credit unions and building societies;
3. Hidden nature of some of borrowing – parents’ top ups etc;
4. Coincident borrowing – with younger households being more likely to engage in borrowing for a mortgage, while borrowing for car purchase etc.
   

BofI, which holds ca 25% of all mortgages in the country (about 190,000) has reported that of these, more than 20% were already in negative equity (over 40,000) around the beginning of 2010.

The aforementioned Bank of England paper provides a good starting point for outlining the set of adverse impacts that negative equity can have on the Irish economy.

Negative equity can have implications for monetary policy:

A rising incidence of negative equity is often associated with weak aggregate demand as households in negative equity are more likely to cut their expenditures across two channels:

• due to reduced marginal propensity to consume out of wealth; and
• due to increased marginal propensity to save.

The direction of causation is not always obvious, implying a possibility of feedback loops – as households experience (or even anticipate) negative equity, they start reducing their borrowing against depreciating assets, the effect of which is amplified by the banks reduced willingness to lend against such assets. In addition, households rationally interpret these declines in today’s wealth as declines in future wealth, implying greater exposure to pensions under-provision in the future, plus greater exposure to the risk of sudden collapse in earnings (due to, say, unemployment or long term illness). As the result, these households tend to reduce their consumption today and in the future.

The reduced consumption leads to a loss of revenue to the exchequer and thus to additional pressures on future public pensions and benefits provision. This, in turn, leads households to further tighten their belts and attempt to compensate for the risk of reduced future benefits by lowering consumption exposures today.

Negative equity tends to become more prevalent when house prices fall, which usually reflects weak demand for housing, since housing supply is fixed in the short term. In the case of Ireland, this is compounded by the fact that we have severe oversupply of properties in the market. Demand effect, therefore, reinforces supply effect. Once again, in Ireland there is one more additional channel of induced market uncertainty due to Nama operations.

Weak housing demand often coincides with weak consumer demand in general, due to

1. reduced availability of credit to consumers and potential home buyers; and
2. precautionary savings as households respond to decline in their nominal wealth.

If negative equity leads to a further contraction in the availability of credit to both households and firms, as in Ireland – exacerbated in the case of Ireland by Nama – second order effects reinforce first order effects.

Lastly, as negative equity in Ireland is coincident with construction sector bust, we have twin effects of decreased households’ mobility and increased unemployment. This once more reinforces the uncertainty levels in the markets for housing, implying that risk-adjusted negative equity becomes even more pronounced here.

Economics 13/06/2010: Mapping Dublin's weight in economy

Here is an interesting set of data for some of the world's leading cities in terms of their contributions to country GDP and their share of total population. Sizes of the bubbles reflect the ratio of contribution to GDP to share of population. Greater Dublin is taken as per CSO: Dublin plus Mid-East region.
To me, this really does put into perspective the necessity for continued investment in the Greater Dublin region and the futility of our serial National Spatial Development Strategies.

We hear so much about the massive urbanization in the emerging economies, especially in the East. This process, in fact, is very much a reality. But what we do not hear about is urbanization of our own economic activity. The fact that Dublin stands out amongst the most urbanized zones, relative to the rest of the country, in the world is telling me that Ireland should focus more attention on developing the Greater Dublin region to reflect the reality of demand of the firms' and workers' for its location.

Updated: see the same chart with Dublin only:
Note: per CSO "The Mid East region (Kildare, Meath and Wicklow) and the Dublin region are affected by a substantial proportion of their workforce living in one region and commuting to work in another." That's as much of a 'definition' as we get to reflect the most likely fact that vast majority of commuters are to Dublin...

And here are the inputs that went into the above charts:
And the source for Dublin figures: National Accounts, regional incomes:
Notice that Dublin City's overall relative weight in the economy (ratio of share of GVA to share of population) rises relative to Greater Dublin, as expected, in line with the evident 'bedroom communities' nature of Mid-East region. Just look at the CSO figure for Mid-East share of GVA.

Economics 11/06/2010: What's going up might be also going down

Irish retail sales have surprised on the positive side, posting a 0.3% increase yoy for sales ex-motors in April 2010. Sounds impressive, especially considering this was the first yoy increase since March 2008, or over some 25 months now. But hold on to that thought of a recovery signal. Check out the charts:
Things are still very much up in the air as to whether retail sales are actually on a mend or not. The figures above plot seasonally adjusted series ex-motors. More importantly, sales in the categories that are correlated with overall household investment activities - household equipment (down 3.1% in value mom, and down 1.2% in volume mom), electrical goods (-3.2% in value mom and 2.3% in volume mom) and Furniture & Lighting (down 5% in value and 6.2% in volume) - all signal no growth in the core leading indicator of a recovery - improved domestic investment. Only Hardware, Paint & Glass category related to investment showed increases of 2% and 4.2% in value and volume in mom terms.

Interestingly, Ireland bucked the EU-wide trend in April:

Economics 11/06/2010: Private Sector Credit data

Central Bank data released yesterday show Private Sector (non-financials) credit fell 9.3% in Q1 2010, to €355 bn. Total outstanding mortgages volume fell €1.2 bn to €146.4 bn. Two thirds of the total amount of credit decline came from writedowns on existing loans, which means that there is continued pressure on loans (keep in mind that Nama transfers are not yet in the data). Charts below update, as usual:
Aggregates first
Notice the rise of securitizations - banks shifting stuff off their balance sheets at an aggressive rate.
Chart above shows monthly flows. There is some improvement here, but absent seasonality corrections it is hard to say what exactly is going on. However, it does appear that the latest monthly transactions uptick is not in line with pre-crisis dynamics for Non-Financial Corps, but in line for Households:Year on year changes:
Clearly, yoy things remain bleak, although the rate of contraction is getting reversed for households. This is a seasonally consistent result, so I would not be reading too deeply into it.

Economics 10/06/2010: CPI & Industrial Production

Host of stats released today point to continued recessionary dynamics in the Irish economy and no turnaround in sight.

First, on consumer prices side. While the usual cheerleaders' squad of 'in-house' economists are singing the swan song of 'deflation is almost over', take a closer look at the composition of CPI changes and you can see that contrary to their claims, prices in categories that represent leading indicators for an uptick are still falling, month on month.

Per CSO: the most significant monthly price changes were

• increases in Housing, Water, Electricity, Gas & Other Fuels (+2.9%), Transport (+0.8%) and Food & Non-Alcoholic Beverages (+0.4%); and
  
• decreases in Clothing & Footwear (-1.1%) and Furnishings, Household Equipment&Routine Household Maintenance (-0.2%).

Detailed sub-indices show that:

• Education rose 9.1% in 12 months to the end of May, 2010
• Housing, Water, Electricity, Gas & Other Fuels was up 3.7%
• Transport was up 4.9%

So the return of inflation in Ireland - a turnaround sign for some - is driven by such hugely value-additive activities as:

1. Hikes in mortgages rates by the banks rebuilding margins (mortgage interest was up 6.1%);
   
2. Liquid fuels price hikes (+8.5% mom) due to our great Government idea of imposing a new tax on fuel which came in effect in May;
3. Higher cost of natural gas, courtesy of our regulated state-owned utility that is now offering competition in electricity markets, while jacking up prices in its core activities;
4. Cost of air transport (up 14% amidst collapsing demand)
5. Higher cost of petrol and diesel;
6. In Recreation and Culture group, there was a 4.1% mom increase in the state-controlled cost of cultural admittance;
7. In education, as numbers of students continue to rise, and as unemployed folks are dreaming about retraining, while financially stretched parents are seeking the ways to cut costs of raising children, our wonderfully accommodating state has ratcheted prices up by 9.1% yoy.

Oh yes, that does really suggest that "demand is improving" and "the economy is turning the corner".

All in, Ireland has now enjoyed an unprecedented 17 months of deflation. In statistical terms, we've hit the bottom and are now returning to positive price inflation territory, slowly but surely, But in economic terms, price increases are driven not by demand, but by the state diktat. desperate to claw as much as possible out of the economy into its own coffers, our state is inventing ever more elaborate schemes to get to our pockets. And with it, the banks too are getting bolder by the day. Instead of a turnaround, all of this smacks of a threat of a renewed pressure on household incomes, and, thus, on the economy.


And, of course, there isn't much of sunshine in the industrial production data released today either. Overall, Irish industrial production was don 11.8% mom in April in terms of production index and up 2.6% in terms of turnover index. Of course, Irish industrial production is the most volatile in the OECD so one must not be tempted to read too deeply into these figures. However, what is clear is that with such dramatic rate of decline, there isn't any signs of an uptick on industrial production side either.

Which, of course, means I am not changing my earlier forecast for GDP growth of -0.3-0.7 in 2010 and GNP growth of -1.0-1.2%. No matter what Ibec or anyone else says...

Economics 07/06/2010: My points from CPA conference

The following is a quick transcript of the main points of my speech at CPA Ireland annual conference last Friday, with some of additional points in brackets.

Friday, June 4, 2010

Ireland is ten quarters into twin crises of credit contraction and house price declines which [can be expected] last for 33 quarters unless radical policy changes are made according to Dr Constantin Gurdgiev. Dr Gurdgiev was speaking at the annual national conference of the Institute of Certified Public Accountants (CPA) in Carton House, Maynooth, today.

Dismissing optimistic reports of an imminent recovery Dr Gurdgiev said: “Since May 2009, we’ve been “turning corners” to a recovery more often than Michael Schumacher on a World Grand Prix circuit.”

According to Dr Gurdgiev, Ireland’s combined Government and economy-wide debt is the worst of any of the other so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) states and the other three EU member states which he groups with them in terms of economic difficulties – Belgium, Austria and the Netherlands (BAN).

“The structure of our fiscal spending is working against us”, Dr Gurdgiev told the conference. “Fiscally we have excessive structural deficits of 50-60% of the total deficit and, courtesy of the banks we are now accumulating off balance sheet structural deficits. Our deficits are the worst in BAN-PIIGS group.”

Ireland’s asset bubble implosion is also set to continue for some time. “Asset bubble crashes last longer than our policies anticipate”, he said. “The OECD average is 10 quarters of credit busts for 18% average contraction and 19 quarters of house price falls for a 29% average price decline. Ireland’s bubble of a 60% decline in credit supply implies 33 quarters of credit contraction and our 50% house price fall implies 33 quarters of price declines. We are currently roughly 10 quarters into these twin crises.”

Compounding these crises is the fact that Ireland has the least competitive economy in the BANPIIGS group in terms of relative unit labour costs. “We haven’t been competitive since at least the mid-1990s”, Dr Gurdgiev contended. “While the latest data from the Irish Central Bank provides some grounds for optimism on the competitiveness front, regaining our overall competitiveness compared to other small open economies around the world will require more hard choices on public sector reforms and restructuring of our public utilities and semi-state service providers.” [You can see more on these points here]

On the other hand, Ireland does have a healthy exporting sector dominated by multinational companies. “But it is struggling against uncompetitive capital, public services and utilities markets, has no credit support and is suffering from capital flight and assets downgrades. Our exporting sector alone cannot carry this economy out of the hole. We are in for a structural recession; unemployment will remain high and employment will continue to fall.” [Notice, I am stressing the word ‘alone’ – it is naïve to believe that we can move out of the crisis on the back of exports. In the longer run, exporting activities will have to dominate the overall economic structure, but we are very far away from this being a reality. More importantly, our exports are being held back – at the indigenous firms’ level – by uncompetitive domestic economic structures, with some of the most pressured areas relating to semi-state companies operations].

Looking at the international picture he claimed there will be decreased pool of foreign direct investment and portfolio investment for Ireland to compete for and there will also be a decreased appetite among investors globally for an ‘Irish story’; “Firm fundamentals will matter in future. In addition, competition for foreign direct investment and portfolio investment amongst the smaller EU states will heat up and as investment diversification becomes more important the flight of capital from Ireland will be significant.”

[There are several things going on here. First on inward FDI – it is clear that Ireland will have to be re-packaged for the future efforts by IDA and EI and in general as a location for inward FDI.

Tax advantage on the corporate side will have to be matched by tax advantages on labour side, especially on skills and entrepreneurship, creativity and knowledge. This means that just as we did with the corporate tax rates, we will have to move to lower tax on premium that skills and other forms of human capital earn in the market place. And this means the need for dramatically re-thinking the system of taxation of labour and the system of taxation in general.

In addition, Ireland will need to get more serious about importing not just raw corporate FDI, but also much higher risk and less anchored entrepreneurial investment. We need to actively pursue young, aggressive, promising start ups and even potential start ups. This too requires re-balancing tax rates, amongst other things, away from taxing labour returns and in favour of taxing immobile and less productive forms of capital. Land is clearly a good target for shifting tax burden.

Ireland will have to re-market itself. We need to put to rest the tourist brochure approach to presenting ourselves and start putting in place real and meaningful changes to our immigration regime, naturalization regime, visa agreements with the neighboring countries. We also need to start thinking about the problems of services provided by the public sector, our cities, to citizens and residents. These services will have to be world class, competitive, easily responsive to demand changes, efficient, individualisable and, frankly speaking, dramatically different from the ‘cattle-em-onto-a-bus’ type of service we supply currently. If Ireland were to become competitive as a location for younger, dynamic, globally mobile highly skilled workers and entrepreneurs of the future (home-grown and foreign alike), the idea of having people on trolleys in dirty hospital halls will have to be buried, fast. The idea of expecting public transport passengers stand in freezing rain for hours waiting for a bus that operates to the bus driver-own schedule has to be binned asap.]

Dr Gurdgiev told the CPA Annual Conference that he did see some opportunities for Ireland’s exporters in the near term, however, particularly among those countries experiencing a relatively high speed recovery - primarily in rapidly developing emerging markets in parts of Asia and to a lesser extent Latin America.

“There is a substantial continued demand for investment in major public infrastructure in these countries [as well as in areas of domestic private demand]”, he said. “These regions are likely candidates for products and services from Ireland, but Irish firms need a differentiator in entering these markets. They have to attract and deploy top talent and deliver meaningful gains to local and foreign clients investing in these regions, while offering the legal and counterparty security of being domiciled in Ireland. The most likely pathway to these markets is by partnering in broader joint ventures with local providers in the countries themselves.” [This too requires a categorical change in indigenous enterprises. The Celtic Tiger ways of hiring ‘bright young foreigners’ for lower grade positions and retaining often unskilled, inexperienced senior staff with legacy tenure will have to go. The glass ceiling for younger and more ambitious and career driven, skilled foreign and domestic younger people will have to be broken.]

Growing knowledge economy in Ireland is the long term solution to Ireland’s economic problems, Dr Gurdgiev argued. “We have no choice but to develop our higher value added, traded services sectors. This is the real ‘knowledge’ economy.

[And I have gone to pains to explain that the ‘knowledge economy’ the policymakers have been talking about is just a small subset of the real knowledge economy. What differentiates my view of the knowledge economy from that of official policy-driven one is that to me knowledge economy reaches across various sectors of services that are largely neglected by our politicians and civil servants. Advertising and new media, e-games, health services, legal services, financial services, design and technology/creativity integration – these are some of the examples of real traded and high value added services that we should be developing here.]

But our prospects are not guaranteed here. The knowledge economy is human capital intensive and our taxation system creates no incentives to invest in human capital. We need to become more human capital focused.

“This requires a maximum flat rate income tax of 20%; a shift of the tax base to property; closing the welfare trap; and reducing the fiscal burden”. [I specifically pointed to the fact that we have a good policy on the books – the Land Value Tax – but that virtually no work is being done today to get this tax implemented in the next Budget. I also clearly stated that this should be a revenue-neutral shift in tax burden, not a new tax grab by the Exchequer. For links to background papers on SVT/LVT see here. On flat tax - back in 2006 I wrote a series of 3 articles in Business & Finance magazine on the issue of Ireland adopting flat income tax. I should dig them up and post them on my long run site...]

“We used to have a more productive and balanced economy”, Dr Gurdgiev concluded. “We’ve lost it to hype and construction, property, credit and fiscal bubbles. We need a productive knowledge based services economy next.”

Economics 07/06/2010: Moving to the next stage in Euro crisis

Last Friday, speaking at the CPA annual conference (will be posting the highlights of the speech here later) I referred to a new 'beast' of the sickly-prickly Eurostates: the BAN-PIIGS. The new bit - 'BAN' - referred to Belgium, Austria and the Netherlands.

Fast forward two days, getting off the trans-Atlantic flight in hot and humid New York guess what hits my news feed? Belgium and France taking in water on the back of Hungary's woes (see earlier post here) and Ukraine is putting some new pressures on Euro area banks. French and Belgian CDS are moving up, while Austria is also back in the spotlight.

Brian Lenihan's announcement that Irish banks will be rolling over €74.2bn of guaranteed loans, bonds, and other systemic support papers before October 1 guarantee is scheduled to run out is not helping the markets either. As Morgan Kelly, Karl Whelan and couple other analysts estimated - once again well ahead of our gallant DofF 'forecasters' - everyone dependent on the Irish government guarantees will be pushing their re-scheduling/roll-overs before October hits.

Surprised? You see - we used to have one main crisis back in 2008-2009: insolvency of banks balancesheets. It should have been resolved directly through recapitalization of the banks via equity take overs by the taxpayers and restructuring of the banks debts. Foolishly, we chose a different path:

• We facilitated banks rolling over debt - as if changing maturity date on the bonds that cannot be serviced changes the level of debt impacting the banks;
• We then proceeded to allow banks to name their capital requirements by allowing them to spread their losses over longer time horizon, as if changing the date of repayments start on a defaulting loan can make the loan perform;
• Following this, we pumped the banks with steroids of ECB facilitated lending - as if swapping few private bonds for ECB loans resolves the problem of balance sheet overhang;
• We created Nama to take bad loans off the banks balancesheets, but, realising the futility of the undertaking, went on to impose unrealistically low haircuts that simply sped up some of the very process of losses recognition in the second bullet point above. Given the levels of real impairments on the loans, Nama only bought banks more time to spread their losses, thus avoiding recognizing the problem of weak balance sheets and amplifying the problem of insolvency;
• Amidst all of this, banks became liquidity traps - sucking up vast amounts of funding. This was not fully satisfied by the ECB, so the banks engaged in predatory re-pricing of performing loans (mortgages etc) in a futile effort to get some more cash flowing;
• The insolvency crisis blew up into a liquidity crisis.
  

So now we have both. And no real way of resolving either or both.

We could have sustained this game, teetering on the brink between full insolvency and a credit crunch, if and only if the euro bonds markets were at the very least stable and the ECB was capable of parking collateral garbage it collected in exchange for banks loans for a long time. Alas, two things are currently under way.

First, the French bonds have slid off their 'safe heaven' pedestal over the last couple of weeks, with spreads over the German bund going up eight-fold since the end of 2009. French bonds are now posing massive liquidity risk to institutionals holding them. French Prime Minister declared last week that: “I only see good news in parity between euro and dollar”. In effect, the French are now openly inviting massive devaluation of the euro - something that is bound to disappoint Germany.

Second, there is no room for more Quantitative Easing, as the ECB has been exposed as an institution that has run out of reserves cover for its own operations. Last week, ECB balancesheet had more than 150% ratio of immediate liabilities to assets held. And that was only for liabilities vis-a-vis Greek rescue package.

Something will have to give, folks. Just as Ireland has precipitated its own implosion by pushing the liquidity crisis on top of our already formidable insolvency crisis, so the ECB and the entire euro zone is now working hard to achieve the same. We are now well behind that point of no return in monetary policy where promises to act with support for the sovereign bonds will be sufficient to stave off a run on the bond yields. Instead, the ECB's rhetoric will be tested, leaving it only one option - start running printing presses.

Now, those of you who followed my writings on the issue will say 'Good, we need a massive - €3-5 trillion - issuance of cash, don't we?' The problem is that while the answer is 'yes, we do', this emission cannot simply involve purchasing of more Government bonds. We need a direct, un-levered injection of new money into the system and it must be broadly based - going not just to the public coffers, but to private economies of the Euro area as well. ECB printing cash to buy Government debt will not reduce the debt levels for the Eurozone sovereigns (which means insolvency problem will remain and will actually increase), nor will it resolve the problem of liquidity crunch in the block (giving money to the Governments to finance roll over of existent debt is about as liquidity-enhancing as burning this cash in a fireplace).

The end game, in my view, can be only across three major disruptions in the euro assets:

• Collapse of the euro below parity of the US dollar; followed by
• Debt restructuring through offers to the bondholders to take a haircut (possible ranges: 35-50% for Greece and Portugal, 25-30% for Spain, 20% for Ireland and Italy, 15-20% for Austria, Belgium... and so on). These will be attempted first privately - via larger institutional consortia, with both sticks (threat of default) and carrots (some sort of delayed tax incentives?) being deployed to get larger institutional holders to accepts a drastic shave off; and once this is underway, the inevitable conclusion to the crisis will be:
• Imposing haircuts on banks bondholders, with the ECB standing by to hose the banks with cash, should liquidity dry up during the haircut imposition.
  

Finale: euro's credibility gone, euro/usd rate below parity persists, inflation will be running ahead of economic recovery and Europe will slide into a Japan-styled long-term depression.

In the mean time, before the end game, expect more bans on trading in various instruments (the French have finally agreed to the German-style ban on naked shorts) and more fiery rhetoric about speculators, destabilizing market forces and other gibberish from the dear leaders of Europe.


PS: All of this reminds me of a conversation I had with one very senior stocks analyst/strategist back in the middle of 2008 meltdown in the markets. I was concerned that the ways in which fiscal and monetary authorities were throwing cash at the banks were going to lead to both running out of policy space to continue accelerated supports for the sector and economy at large. "Charged by the bear, make sure you don't run out of all bullets early on. You might miss," I insisted. In response I was given a complete assurance that resolute actions on large scale (equivalent to unloading the entire magazine of ammunition at the shadow of the problem before actually having an idea as to what the problem really is) will mean that the 'Bear won't be charging for long'. I wish I was wrong... He still writes daily, weekly and monthly missives about the investment strategy for clients.

Economics 05/06/2010: Exchequer returns May 2010

May tax revenues are behind Budget plan, as talk about recovery is intensifying.

Recall, April was the month of allegedly improved (aka above the plan) tax revenues. May came in, bringing about a double whammy:

1. cyclical components were trending tax revenue down. As normal and forecasted by the DofF;
2. non-cyclical trend was also down, which was not predicted by DofF.
   

Oops. Tax revenue came up to €3.11bn in May or €141mln behind the target. This brought the annual (to-date) position on revenue side to some €148mln below target. Annualized rate of revenue decline is down to 10.4% (massive, still) from 10.8%. Budget assumes that tax revenue for 2010 will be 6% behind 2009 - €31.05bn instead of €33.04bn collected for 2009. I don’t want to venture a forecast here, but we are clearly in the uncharted waters of volatile bottom bouncing.

Here are my charts, per usual:
Chart above highlights seasonal cyclicality: Tax revenue up in May – just as it done in 2008 and 2009, but the swing is shallower than in previous 2 years. Total revenue uptick in May is better than in 2008 (when there was actual slight decline in the series), but the same as in 2009. Total expenditure is down, just as it did in May 2008 and 2009, although decline in 2008 was stronger. So we are somewhere in-between in terms of dynamics – neither 2008 with its calmer Exchequer conditions due to lags on revenue side, and the extremely disastrous 2009.

To-date, 2010 is shaping out to be on a slightly better local trend than the linear trend line for 2008-present, when it comes to tax receipts, although the local trend is still downward. Ditto for the upward trend in expenditure. Notice that we undershot expenditure trend by about as much as in 2008 and there is a significant improvement on 2009.

In short, there is no dramatic change between previous years and today. The crisis is still in full bloom, folks.

Some annual comparisons due:
You can clearly see how in comparative terms, monthly receipts so far been coming in at below 2009 levels except in March. Was that a boost due to scrappage scheme and the combined effect of 2010 license plates luring in the silly vanity buyers (we still do have folks who think a lower range car with 2010 plates beats a higher range one with 2007 ones – the Celtic Hamsters, as I would call them: stripes and all, but clearly short of Tigers. Also, notice that May 2009 uplift in receipts brought the monthly figure closer to May 2008 than current uplift shifted us toward May 2009.

Here is a crude comparative to the ‘target line’ – drawn based on the basis of -6% deviation in receipts. Now, these are monthly receipts, so it is not exactly coincident with the ‘real’ DofF target line (which, frankly, I can’t be bothered to trace as it is irrelevant, as long as the annual target is set at 6%). If you assume that there will be a pick up in revenue (outside the seasonality factors) in the second half of the year, hold your hopes for the annual figure to come on-target. However, my ‘target’ line is telling:
We are clearly underperforming the ‘target’ so far, although we are moving close to it. Another interesting feature is the comparative between the ‘target line’ and 2008 revenue, clearly showing that we are in for another shocker of a deficit even if we hit the target. The reason is simple – our current expenditure is not really declining significantly relative to 2008. Which means that unless revenue surprise in H2 2010 will be a massive one, the deficit is going nowhere compared to the 7-9% objective set out by our counterparts in the PIIGS.

Chart above shows another set of comparatives. This time on the expenditure side and deficit. On the expenditure side, we are running much closer to 2008 figure this year than in 2009. But we are still above the 2008 level. On deficit side, we are better off than in 2009 since March, but still worse than in 2008, although the gap is closing in May relative to January-March. One wonders what will happens once the latest Live Register changes hit the unemployment rolls and their income taxes stop flowing in, over months ahead. Remember, there are lags here as some of the redundancy payments are taxable.

Now, look at cumulative receipts to date:It is clear just how resilient our underperformance, relative to 2009 and 2008 is over the 5 months of 2010. Take a look next at total receipts, with the aforementioned ‘target line’ in:
Again, underperformance is evident. What is dramatic, however, is that after rounds upon rounds of various tax increases, charges, duties etc rises, we are still nowhere near seeing an uplift in tax revenues. A Laffer curve? Perhaps. Alternatively – collapse of the tax base? May be both. It is, nonetheless clear that following the Unions-suggested path of ‘tax em, don’t cut spending’ is not an option.

Total expenditure comparatives. There has been much said – domestically and internationally – about dramatic cuts in public spending. Really, folks?
Tell me if I am not seeing something, but the yellow line is not showing any really dramatic cuts – not the ones you’d expect for a country with 14% deficits.

Suppose we decided to cut half of our deficit out of expenditure side alone (presuming the other half comes out of increased revenue – despite this being unrealistic, entertain such a possibility). Let’s call this scenario ‘½ target line’. Alternatively, suppose the entire adjustment to 3% deficit was to be carried out of expenditure side – call this scenario ‘full target line’. The following will be consistent with an expenditure target, relative to 2009:
So we are doing no too poorly in terms of ‘half-target’ line, implying that the Government is aiming to either dramatically raise taxes (and hope that it will result in a significant revenue uptake), or they are hoping to discover some sort of precious metals deposits somewhere in the bogs, perhaps at the end of a rainbow. Otherwise, we are not on track to any fiscal recovery, just to a moderate decrease in the deficit.

To Government’s credit, however, let us note that spending is down 8.9% yoy over the first 5 months. Then, of course, to their discredit – most of this decline came out of cuts to capital spending. Note also, reductions in spending are running on 2009 figures. That means that yoy we are currently saving some €1.7 billion (over 5 months) – a sizable chunk. Capital side of spending accounts for €890mln of that. Sounds like pretty fair? Well, not really – capital spending last year was held back until later in the year. Which means that in real terms, capital spending in the first 5 months of 2010 is a whooping 36% down on the same period in 2009 and is running at roughly 20% below 2009 annualized rate of spend. And the source of these capital savings? Oh – DofTransport and DofEnvironment – the two account for some 70% of the cumulative 5-months shortfall.

So the strategy might be: cut spending on roads and transport, charge people more for poor quality commute (‘carbon’ tax and fuel excises) and replenish the coffers… In other words, don’t dare call it a tax on income, but the twin contraction in investments in improving transport and expansion of taxes on commute are in the end exactly that. Unless, of course, you are in the Dail or Seanad – in which case, it’s Alice in Wonderland life for you, courtesy of commuting subsidies.

Current spending is only 5% below last year’s, generating savings of €850mln – bang-on with expectations. This masks two sub-trends:

• There has been 10.5% drop in overall current spending outside the Dof Social Welfare/Protection; and
• DofSocial Protection is running up 13.1% on current expenditure. Wait, as I’ve said before, until the latest additions to Live Register kick in and before a significant wave of long-term unemployed start getting into much more extensive social welfare benefits.
  

Final comparatives, therefore:
Yes, the deficit is improving on cumulative basis and on 2009. But we are far off the deficit figures for 2008 and our dynamics are pointing to no convergence toward 2008. Now, recall that in order to return back to 2008 deficits we need to also take into account that since 2008, Irish economy has contracted significantly. In other words, the task of restoring 2008 deficit levels (not spectacular either) will take even more cuts out of us today than we are so far willing to deliver.

Economics 05/06/2010: Economics of Fiscal Stimulus

This is an unedited version of my article for June-July issue of the Village Magazine.

Weeks into a new round of ‘talks’ over the public sector reforms and Ireland’s Policy Kindergarten squad is getting more agitated by the issue of cuts in the Government expenditure. The logic of their arguments, led by the likes of Tasc, the Irish Times, and an army of Unions-employed ‘economists’, is perverse: “In order to get the economy back on track, we need to borrow more and spend on public services and wages.”

There are three basic arguments why stimulating Irish economy though increased public spending won’t work in the current conditions even in theory, let alone in practice. These are: the structural nature of the fiscal crisis we face, the size of the debt we face, and the lack of evidence that stimulus can work in a country like Ireland.

Structural deficits

Economists distinguish two types of deficits: cyclical and structural. The first type of deficits occurs when a temporary economic slowdown leads to an unforeseen decline in revenue and acceleration of certain components of spending (e.g. unemployment insurance and social welfare). By its definition, the cyclical deficit will be automatically corrected once economy returns to its long term growth path.

In contrast, structural deficits are those that arise independently of the short term changes in economic growth. They are the outcome of unsustainable increases in permanent spending and/or decline in the long term growth potential that might arise from a severe crisis.

In the case of Ireland, both of the latter factors are at play. Various estimates of the extent of structural deficits carried out by the likes of IMF, OECD, the European Commission, ESRI and independent analysts range between one half and two thirds of the 2009 General Government deficit, or 7-9.5% of GDP.

Reckless expansion of Government spending in the period of 2001-2007 is the greatest cause of these – not the collapse of our tax revenue. In the mean time, our economy’s long-term growth rate has declined from the debt-and-housing-fueled 4.5% per annum to a Belgium-like 1.8% per annum.

In 2000, General Government Structural Balance stood at roughly -0.5% of GDP. By 2008 this has fallen to almost -11% courtesy of a massive build up in permanent staff increases in the public sector, rises in welfare rates, explosion in health spending and creation of a gargantuan army of quangoes and supervisory organizations.

Forget, for a second, that majority of these expenditures represented pure waste, delivering nothing more than top jobs for friends of the ruling class, plus scores of jobs for public and quasi-public sector workers. Between 1981 and today Ireland has recorded not a single year in which Government structural balance was positive. Windfall stamps, VAT and capital gains tax receipts over 2001-2007 have masked this reality, as Goldman Sachs structured derivatives masked the reality of Greek deficits.

We are not getting any better

Over the recent months, the Government has been eager to ‘talk up’ our major selling points. Ireland, it goes, is a country with stabilized public finances and low debt to GDP ratio.

Last month, Eurostat exposed the lie behind the ‘stabilized public finances’ story. It turns out our Government has decided to sweep under the carpet billions of cash it borrowed in 2009 to recapitalize Anglo. Courtesy of this, our deficit for 2009 was revised to a whooping 14.3% of GDP – topping that of Greece.

But Irish General Government deficit this year is expected to come in between 11.7% and over 12% of GDP, depending on who is doing the forecasting – Department of Finance or ESRI. And this is before we factor in March 2010 statement by the Minister for Finance, promising over €10 billion for the banks this year. This means that, as the rest of the world is coming out of the recession, our fiscal deficit for 2010 is expected to either match or exceed the revised level achieved in 2009. Some stabilization.

Irish Government debt is expected to reach 78-82% of GDP by the end of 2010 – on par with Eurozone’s second sickest economy, Portugal. With Nama and banks recapitalizations factored in, Irish taxpayers will be in a debt hole equal to between 117% and 122% of GDP by 2011 and to 137% by 2014. At the point of the Greek debt crisis implosion last year, Greece had second highest debt to GDP ratio in the EU at 117%, after Italy with a massive 119%.

In totality, current crisis management approach by the Irish State is going to cost every Irish taxpayer in excess of €117,000 in added tax liability. Neither Iceland nor Greece come close.

Economy on steroids

Still think that we should be stimulating this economy through more borrowing?

Take a look at the private sector debts. In terms of external debt liabilities, Ireland is in the league of its own amongst the advanced economies. Our overall debts currently are in excess of the critically high liabilities of the HIPCs to which we are sending intergovernmental aid. And rising: in Q3 2009, our external debt liabilities stood at a whooping USD 2.4 trillion, up 10.8% on Q3 2007. Of these, roughly 45% accrue to the domestic economy – more than 6 times our annual national income.

Ireland’s share of the world debt is greater than that of Japan and more than double that of all BRICs combined, once IFSC companies are included. Over the next 5 years, the entire Irish economy will be paying out around €206,000 per each taxpayer in interest on this debt. Adding more debt to this pile is simply unimaginable at any stage, let alone when the cost of borrowing is high and rising.

These figures show that the main cause of the current crisis is not the lack of liquidity in the system, but an old-fashioned problem of insolvency.

This problem is directly related to the actions of the Irish state. Over the last decade, there was a nearly 90% correlation between the average increases in the Irish tax revenues plus the rate of economic growth and the expenditure growth on capital and current spending sides. In effect, courtesy of the ‘Boom is getting boomier’ Ahearn/Cowen team Ireland had two bubbles inflating next to each other – a private sector borrowing bubble and a public sector spending one. Government’s exuberant optimism, cheered on by the Social Partners – the direct beneficiaries of this ‘fiscal policy on steroids’ approach – explains why during Brian Cowen’s tenure in the Department of Finance, Irish structural deficit doubled on his predecessor’s already hefty increases.

But what went on behind the glossy Exchequer reports was the old-fashioned pyramid scheme. Some got rich. Temporarily, we had an army of politically connected developers and bankers stalking the halls of premier cars dealerships and property auction rooms.

Permanently, an entire class of public employees reaped massive dividends in terms of shares in privatized enterprises that cumulated in their pension plans. Current claims that because the values of some of these payoffs have declined over time (often due to the intransigent nature of the unions in the semi-state companies, staunchly resisting change and productivity enhancing reforms) is irrelevant here. Prior to their privatization, these companies were called 'public' assets. Creation of any, no matter small or large, private gains to their employees out of the companies' privatizations or securititization through pensions funds liabilities of their assets in favor of employees, therefore, is nothing more than an arbitrary, unions-imposed grab of the public asset.

Benchmarking, lavish pensions and jobs security – also paid out of the economy leverage (just think of the NPRF - explicitly created to by-pass the illegal, under the EU rules, taxation of economy for provisioning for future public sector pensions liabilities) – was a cherry on top of the cake. Public companies management got dramatically increased pay and a permanent indemnity against competition through a regulatory system that was all but a client of their semi-state companies.

From our hospital consultants to our lawyers, academics and other professionals – a large army of state-protected, often non-competitive internationally professional elites collected state-subsidised pay so much in excess of their real productivity that we became the subject of diplomats’ jokes.

Our state’s response to this was telling. Just as the country was borrowing its way into insolvency, our Government gave billions to aid developing nations. That was the price our leaders chose to pay to feel themselves adequate standing next to Angela Merkel and Nicolas Sarkozy at the EU summits. Incidentally, as the country today is borrowing heavily to cover its basic bills, Brian Cowen still sends hundreds of millions of our cash to aid foreign states and has recently decided to commit over €1,000 million – full year worth of the money he clawed out of the ordinary families through income levies – to the Greek bailout package.

Economics on Steroids

Still think more state-centred economy is the solution to our problem? Irish economists, primarily those affiliated with the Unions are keen on talking about the ‘positive multiplier’ effect of deficit-financed stimulus. Sadly for them, there is no conclusive evidence that borrowing at 5 percent amidst double-digit deficits and ‘investing’ in public services does any good for the economy.

Firstly, one has to disregard any evidence on fiscal stimulus efficiency coming out of the larger states, like the US, where imports component of public and private expenditure is much smaller than in Ireland. The US estimates of the fiscal stimulus multiplier also reflect a substantially lower cost of borrowing. Even if Ireland were to replicate US-estimated fiscal stimulus effects, higher cost of our borrowing will mean that the net stimulus to Irish economy will be zero on average.

Second, international evidence shows that for a small open economy, like Ireland, the total fiscal multiplier effect starts with a negative -0.05% effect on economic growth at the moment of stimulus and in the long run (over 6 years) reaches a negative -0.07-0.31%. Add the cost of financing to this and the long-term effect of deficit financed stimulus for Ireland will be around -2.3% annually.

Third, no one on the Left has a faintest idea what the new spending should be used for. Simply giving borrowed cash to pay the wage bill in the public sector would be unacceptable by any ethical standards. Any investment that is bound to make sense would have to focus on our business centre – Dublin, where infrastructure deficit is acute and potential demand is present. Alas, this will not resolve the problem of collapsed regional economies. Pumping more cash into the ‘knowledge economy’ absent actual knowledge infrastructure of entrepreneurship, private finance, skills and without a proven track record of exporting potential, is adventurist even at the times of plenty.

In short, the idea that expanded deficit financing will support any sort of real recovery in the economy is equivalent to arguing that pumping steroids into a heart attack patient can help him run a marathon.


Ireland needs severe rethinking and reforms of the grossly inefficient and ethically non-sustainable spending and management practices of our public sectors. It should start with significant rationalization of expenditure first and then progress to a more deeply rooted revision of the public sector objectives and ethos.

Ireland also needs a significant deleveraging of what is a basically insolvent economic structure. This too requires, amongst other things, a significant reduction in overall public spending. Far from ‘borrow to spend’ policies advocated by the Left, we need ‘cut to save’ policies that can, with time, yield a permanent increase in the national savings rate, productive private investment and improved returns on education and skills. Otherwise, we might as well give our college graduates a one-way ticket out of Ireland with their degrees, courtesy of Tasc and the Unions.