Economics 16/9/10: Analysis of global banks rescue packages disputes Irish policy case

A very interesting paper that a year ago should have alerted this Government to the fallacy of its preferred path to interventions in the banking crisis. Alas, it did not.

Michael King Time to buy or just buying time? The market reaction to bank rescue packages, BIS Working Paper Number 288, September 2009 (linked here).

The paper suggests and tests the following three hypotheses concerning banks rescue packages put in place at the beginning of the crisis (January 2008):

• H1: The announcement of government rescue packages will be associated with a narrowing of bank CDS spreads relative to the market.
• H2: Capital injections will be associated with a rise in bank stock prices relative to the market if the benefits of lower leverage and a lower probability of financial distress outweigh the potential dilution of existing shareholders or restrictions on payment of common dividends.
• H3: Asset purchases and asset insurance will be associated with a narrowing of bank CDS spreads and a rise in the stock price relative to the market.

What the study found is that rescue packages confirm H2. But there was significant difference in the effectiveness of interventions.

• In the US, “bank stock prices outperformed reflecting the decline in the probability of financial distress and the favourable terms of the capital injections. The risk of US bank failures was high following the failure of Lehman Brothers and IndyMac, and the government take-over of AIG, Fannie Mae, and Freddie Mac. While the US Treasury’s preferred shares included warrants with the potential to dilute shareholders, the favourable terms of the capital allowed the average US bank share to outperform the market following the announcement of government support.”
• In contrast in Europe, “the risks of financial distress were also high as seen in the capital injections for Fortis and Dexia and the nationalisation of Bradford & Bingley. While banks were recapitalised, the cost and conditions of European rescue plans were punitive for existing common shareholders leading to an underperformance of bank stocks in most countries.” In other words, Europeans, predictably soaked equity holders but didn’t touch bondholders.
• “The UK package appears to have been the most costly for existing shareholders, which explains the fall in stock prices when the terms were disclosed. Given that only three out of six banks accepted the capital, the fall for banks receiving capital was offset by the positive response of banks that did not.”
• “Swiss banks were the exception as the average Swiss bank was relatively unaffected.”

Turning to the cases of asset purchases or asset insurance schemes, “market reaction provides only partial support for the third hypothesis (H3) that creditors took comfort from the reduction in potential losses and the decline in risk-weighted assets”. Oops, I’d say for the Leni/Nama plans. And this was known as of September 2009, despite which our Government has charged ahead with Nama.

“Overall, globally, asset purchases or insurance were used in only four cases with mixed results.”

Bingo – only in 4 cases: “the Dutch, Swiss, and US governments supported specific financial institutions by purchasing impaired assets or providing insurance against losses on specific portfolios. In an asset purchase, the government buys impaired securities or loans from the bank, reducing the bank’s risk-weighted assets and lowering the amount of capital it must hold against potential losses. While the government bears the risk of losses, it also retains the profits if the assets recover. While the US and Germany announced asset purchase plans, only the Swiss had taken action by the end of January 2009, buying $39.1 billion of illiquid assets from UBS on 16 October. The assets were removed from UBS’s balance sheet and placed in a special purpose vehicle, significantly reducing UBS’s risk.”

So in the end in the duration of 2008, no country has undertaken a significant Nama-like operation with exception of Switzerland in relation to UBS alone. Clearly the claim that Minister Lenihan was acting consistently with other countries in setting up a Nama vehicle is not true.

Here’s an interesting bit: see if you can spot where Mr Lenihan has gone the path differing from everyone else back in 2008. “Under asset insurance, the government assumes a share of the potential losses on a specified portfolio after a first loss amount (or deductible) is absorbed by the bank. In return, the bank pays the government an insurance premium based on the riskiness of the portfolio. By limiting the bank’s potential losses, asset insurance also reduces a bank’s risk-weighted assets and lowers the capital it must hold. The government, however, is left with a large potential liability if the assets fall substantially in value. The US and the Netherlands offered asset insurance to three banks. The US provided protection to Citigroup and Bank of America against the possibility of unusually large losses on asset pools of $301 billion and $118 billion, respectively. In both cases, the US government bears 80% of the losses after the deduction of a first loss tranche paid by the bank but does not share in any profits. The Dutch authorities created an illiquid asset backup facility to insure most of the risk from $35.1 billion of Alt-A securities owned by ING. The Dutch government shares in 80% of the downside and the upside. Asset purchases or asset insurance should be positive for both the stock price and the CDS spread, as both interventions lower the potential losses faced by common shareholders and reduce the risk of default. As a result, the share price should rise and CDS spreads should narrow. In three out of four cases the government’s actions coincided with the injection of capital.”

To conclude: “the October [2008] rescue packages provided governments with time to assess the situation and formulate their policy responses. At the same time, these policy interventions did not represent a buying opportunity as seen in the underperformance of bank stocks in most countries studied.”

Predictably, our stockbrokerages analysts, Nama, Department of Finance, Government and the usual crowd of suspects claimed that:

• Nama will lead to significant improvement in the banking sector health;
• Irish Government interventions were value additive for shareholders - all stockbrokers in Dublin and majority of them outside had 'Buy' recommendations on banks based on Government rescue package;
  
• Banks guarantee scheme is structurally important to the resolution of the crisis (not a delay, but a resolution),
• The rest of the world was doing the same.

International evidence on the matter suggests that banks supports are only as good as the measures to reform banks taken after the supports enactment. Of course, in the case of Irish banks, no such reforms took place since September 2008.

All I need to add here is that this paper was available to Minister Lenihan's advisers, to Nama and to DofF and Central Bank handlers. The latter, alongside their Financial Regulator counterparts are linked to BIS.

Economics 16/9/10: Why a rescue package for Ireland might not be a bad idea

This is an edited version of my article in today's edition of the Irish Examiner.

Two weeks into September and the crisis in our sovereign bond markets continues unabated. Ireland Government bonds are trading at above 6% mark and given the perilous state of the Irish banks, plus the path of the future public deficits, as projected by the IMF, Ireland Inc is now facing a distinct possibility of our interest bill on public debt alone reaching in excess of 6% of GDP by 2015. [Note: by now, the magic number is 6.12% as of opening of the markets today].

Sounds like a small number? Here are a couple of perspectives. At the current cost of deficit financing, our Exchequer interest bill in 2009 was 1.7% of GDP or €2.8 billion. Within 5 years the interest bill can be expected to reach over €12 billion, based on the Government own projections for growth. By this estimate, some 30% of our expected 2015 tax receipts will go to pay just the financing costs of the current policies.

It is precisely this arithmetic that prompted the Financial Times this Monday to question not only the solvency of the Irish banking sector, but the solvency of the Irish economy. The very same inescapable logic of numbers prompted me to conjecture in the early days of 2009 that our fiscal and banks consolidation policies will lead to the need for an external rescue package for Ireland.

This external rescue package is now available, fully funded and cheaper (financially-speaking) to access than the direct bond markets. It is called the European Financial Stability Fund (EFSF). More than money alone, it offers this country a chance to finally embark on real reforms needed to restore our economy to some sort of a functional order.

The EFSF was set up to provide medium term financing at a discounted rate of ca 5% per annum for countries that find themselves in a difficulty of borrowing from the international markets. With effective yields on our bonds at 6.05% and rising – we qualify.

The EFSF requires that member states availing of European cash address the structural (in other terms – long term) deficit problems that got them into trouble in the first place. In Ireland’s case this is both salient and welcomed.

It is salient because, despite what we are being told by our policymakers, our problems are structural.

Banks demands for capital from the Exchequer – a big boost to Irish deficit last year and this – are neither temporary, nor dominant causes of our deficits. In the medium term, we face continued demands for cash from the banks. By my estimates, total losses by the Irish banks are likely to add up to €52-55 billion (ex-Nama) over the next three-four years. These can be broken down to €36-39 billion that will be needed in the end for the zombie Anglo, €6bn for equally dead INBS, at least €8 billion for AIB and up to €2 billion for the ‘healthiest’ of all – Bank of Ireland. These demands will come in over the next 24 months and face an upside risk should ECB begin aggressively ramp up interest rates in 2011-2012.

No economy can withstand a contraction in its GDP on this scale. Least of all, the one still running 5-7% of GDP structural deficits over the next 4 years. In 2009, banks demands for Exchequer funds managed to lift our deficit from 11.9% to 14.6%. This year, absent banks bailouts, our deficit will still reach around 11.3%. Only 3.3% of that due to the recessionary or temporary effects. In 2011, IMF estimates our structural deficit alone to be 7% and 5.9% in 2014.

Which brings us to the point that the use of the EFSF funds should also be a welcomed opportunity for Ireland.

A drawdown on EFSF funding will automatically trigger a rigorous review of our fiscal plans through 2015 by the European and, more importantly, IMF analysts. This is long overdue, as our own authorities have time and again proven that they are unable to face the reality of our runaway train of fiscal spending.

Since 2008 in virtually every pre-Budget debate, Minister Lenihan has been promising not to levy new taxes that will threaten jobs and incomes of the ordinary people of Ireland. In every one of his budgets he did exactly the opposite. Under the EFSF, the IMF will do what this Government is unwilling to do – force us to reform our tax system to broaden the tax base, increase the share of taxes contributions by the corporate sector and start shifting the proportional burden of taxation away from ordinary families.

Minister Lenihan has repeatedly promised reforms of spending. In every budget these reforms fell short of what was needed, while the capital investment was made to bear full force of the cuts. Drawing cash from the EFSF will make Mr Lenihan scrap the sweetheart Croke Park deal and start reforming current spending. Politically unacceptable, but realistically unavoidable, deep cuts to social welfare, public sector employment and wages, quangoes, and wasteful subsidies will become a feasible reality.

Starting with December 2009, the Irish Government faced numerous calls from within and outside this state (headed by the EU Commission and the IMF) to provide clarity on its plans to achieve the Stability and Growth Pact criteria of 3% deficit to GDP ratio by 2014-2015. The Government has failed to do this. Drawing funds from the EFSF will help us bring clarity as to the size and scope of fiscal adjustment we will have to take over the next 5 years.

Lastly, the EFSF conditions will include a robust change in the way we are dealing with the banks. Gone will be the unworkable Government strategy of shoving bad loans under the rug via Nama and drip-recapitalizations. These, most likely, will be replaced by haircuts on bond holders and equity purchases by the State.

Contrary to what the Government ‘analysts’ say, drawing down EFSF funds will not shut Ireland from the bond markets. Instead, swift and robust restoration of fiscal responsibility and more a more orderly exit of the exchequer from banks liabilities are likely to provide for a significant improvement in the overall markets perception of Ireland. After all, bond investors need assurances that we will not default on our debt obligations in the future. Only a strong prospect for growth and recovery can provide such an assurance. Ministerial press releases and Nama statements are no longer enough.

Economics 16/9/10: One sick pup lifts one ear

Funny thing the market is, at least if you are an Irish banker.

The rationale for AIB selling its profitable divisions to plug the holes in its collapsed domestic business (notice, more detailed analysis of exactly the same fundamentals argument was supplied by Prof Brian Lucey back in March in his article in the Irish Times - see here). The logic of this AIB's perverse move was:

• sell the stakes in M&T and BZWBK to provide capital to write down bad loans on homegrown turf;
• put the bank assets squarely into the geography where it has proven time and again to be incompetent in lending (aka Ireland);
• reinforce the incompetence of the management of the bank by showing to the rest of the world that over the last 10 years, AIB could manage to make money only in those divisions/investments where it had no managerial say (I mean, really, folks - AIB's competent managers - who need to be paid wages comparable to other bankers around the world, cause, you know they are being actively headhunted by global banking syndicates for their ability to turn funding into bad loans - had nothing to do with only two profitable sides of the bank: M&T and BZWBK)

Ex post the sale of BZWBK, the AIB therefore anticipated markets to rush to their rescue. This clearly is not what's on the minds of the markets. S&P last night held its A-/A-2 credit rating on AIB and the negative outlook, implying a new downgrade might be in the works. Oh, how dare they?

AIB needs not €7.4bn (the minimum regulatory requirement capital top up), but more like €10bn to plug the hole in bad loans. It has managed to under-report (thanks to an accounting rule) losses in H1. The bank is now being stripped of the very few assets it has that actually make sense, leaving it with the legacy of its own actions and choices that is purely toxic. The markets don't buy the management 'plan' (what plan?) nor do they by the management team itself. The only thing that separates AIB from heading the Anglo route is the willingness of the Government to throw taxpayers guarantees and cash at the bank to rescue its shareholders and bondholders. How long will that last is an academic point at this moment in time. The real point is - AIB simply has so far shown no capacity to produce viable banking business short of buying into foreign-run assets.

Economics 16/9/10: Improving competitiveness

Recently, there have been plenty of claims concerning improving Irish competitiveness through the crisis. Most refer to the Irish Central Bank-reported Harmonized Competitiveness Indicators (HCIs). Here are some charts to detail what has been going on in this area:

The first chart below shows historical trends in HCIs.

On the surface, it looks like:

1. The story of dramatic improvements in our competitiveness (at least as measured by the HCIs) has been true - we are now back to competitiveness levels not seen since June 2007 (in Nominal HCIs), February 2003 (when it comes to HCIs deflated by consumer prices) and January 2006 (as measured by HCIs deflated by producer prices)
2. At the same time, the gap between our performance in HCIs deflated by producer prices and consumer prices clearly shows that these gains in competitiveness were not due to producer cost deflation (improved productivity), but due to massive deflation in consumer prices (margins erosion and collapse in domestic demand).

A closer look in the chart below, however, shows that the timing of our competitiveness gains is not as straight forward as the arguments put forward in the public suggest:
Starting with the peak year for our bubble (2007), our gains in competitiveness since the beginning of this recession in Q1 2008 are hardly impressive at all. To summarize these, here is a table of relative changes:

Loss of 1.4% (nominal) in competitiveness, contrasted by gains of just 2.4% in producer prices-termed HCI and 5.6% in consumer prices-termed HCI are hardly a matter of bragging rights for Ireland Inc.

Irish HCI data is strongly suggesting that so far in the recession, Ireland's producers have failed to gain significant inroads into productivity gains. Instead, lower retail prices so far remain the primary drivers of the improved indices reading.

Economics 16/9/10: Migration & natives mobility

In my presentation yesterday at IBM's Extreme Blue event, I mentioned that we know very little about the location decisions of the modern migrants - people with high skills, education, aptitude, creativity and innovation capacity.

An interesting new study from the Bank of Italy (“HOW DOES IMMIGRATION AFFECT NATIVE INTERNAL MOBILITY? NEW EVIDENCE FROM ITALY by Sauro Mocetti and Carmine Porello, Working Paper Number 748 - March 2010) assessed the relationship between “native internal mobility and immigration in Italy”. The study attempts to analyse “the impact of immigration on local labour markets and to gauge the consequences for the socio-demographic composition of the local population”.

Traditionally, immigration into a given geographic region is seen as a driver of outward migration of the natives due to jobs displacement (the argument that by taking lower wages migrants force indigenous workers out of their jobs). This is known as a substitution effect. Alternatively, there is a view out there that migration induces clustering of both migrants and domestic workers.

A set of studies in the 1990s and early 2000s have produced mixed results as to the relationship between inward migration and flows of the native workers:

• Frey (1996) shows “a strong correlation between immigrant inflows and native outflows in US metropolitan areas, and argued that this behaviour was bringing about a ‘demographic balkanization’”. Borjas et al. (1997) report a strong negative correlation between native net migration and immigration from abroad. Hatton and Tani (2005) find a negative displacement effect in the UK. Brűcker et al. (2009) find that “foreign immigration replaces native internal mobility in Italy”. (substitution in levels)
• Wright et al. (1997) disagree by showing that “immigrant inflows are unrelated to native outflows in large metropolitan areas.” Card (2001) confirms this in a broader setting. (independence)
• Card and DiNardo (2000) find that “increases of the immigrant population in specific skill groups lead to small increases in the population of native-born individuals in the same skill group.” (clustering)
• Borjas (2006) finds that “immigration is associated with lower in-migration rates, higher out-migration rates, and a decline in the growth rate of the native workforce.” (substitution at the level of growth rates)

In their study, Mocetti and Porello find that “immigration has a negligible impact on overall native mobility while it does have a significant impact on its skill composition” in Italy. Crucially, immigration leads to

• a displacement of low-educated natives,
• immigrant clusterization in the northern regions has partially substituted South-North mobility flows of less-skilled natives,
• immigration is positively associated with highly-educated native inflows
• the impact is concentrated among the young population and is somewhat stronger in more urbanized areas.

Interestingly, the devil is not in the details, but in interpreting the results: “is not clear how these results may be interpreted. If we consider the arguments in the literature on labour, we should read these findings as evidence of the substitution effect for low-educated natives and of complementarities for highly-educated ones. Task specializations and complementarities between immigrants and highly-educated natives might induce higher demand (and productivity) for natives in areas with a higher share of immigrants; having said this, if low-educated natives and foreign workers compete for the same jobs, then immigration might have a depressive effect on labour demand for natives.”

Labour market story aside, and related to our own study at the Institute for Business Value (here), immigration has skills-specific effects on internal mobility due to what I would term quality-of-life considerations. Inflow of migrants can alter quality of state in the recipient city. Mocetti and Porello refer to this effect as “the impact of immigration on natives’ location choices [that] might also work through other channels such as the housing market and the preferences for ethnic composition of the local context.”

Their study includes “house prices in the regressions to control for the effects through the real estate market; regarding “racial” preferences, they are likely to affect neighbourhood choice within a city rather than displacements across regions. Therefore, we argue that our estimates can be reasonably interpreted as the result of the interaction between immigrants and natives in the labour market.” The authors find that housing costs, associated with higher inward migration, do have a negative effect on the regions’ ability to retain domestic workers of similar skills levels.

So on the net, while the study does not deal specifically with the high quality of human capital group involved in migration, the study does suggest that better skilled/educated workers tend to produce a clustering effect leading to complementarity with the native workers of similar skills and creating a pull factor for inward migration of highly skilled workers to a specific location. The offsetting deterioration in living conditions (due to higher house prices etc) is not sufficient in size to cancel out this positive effect.

Economics 13/9/10: FT's belated recognition of Irish realities

In today's FT (here), Wolfgang Munchau clearly states that (emphasis is mine): "...Irish banking sector is insolvent, and there are questions about the capacity of the Irish state to absorb those losses. ...two years have passed [since the crisis acknowledgement by the state] and nothing has been resolved.

…As we saw last week, this strategy [of shoving bad loans under the rug via Nama and quasi-recapitalizations] came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bail-out may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth.

[Note: this blog has previously (here), on a number of occasions estimated the overall impact of the net losses realized by the banks to Irish taxpayers will be in the region of €62-75 billion, inclusive of Nama. Based on the Department of Finance own figures, this can be expected to amount to 38.5-46.6% of Ireland’s 2010 GDP or 48-58.1% of our GNP. Either range of numbers is significantly in excess of Munchau’s back-of-the-envelope estimate.

However, even at 30% of annual GDP, the expected hit on this economy from the banking sector debacle is simply insurmountable.

No economy on earth can be expected to withstand a 30% contraction in its GDP over two-three years, while still running a 7-8% of GDP structural deficit in every one of these years. The insolvency of Irish banks recognized by Munchau, therefore, automatically implies the insolvency of our economy, unless the banks are isolated from the rest of our economy by a removal of the blanket guarantee on the bondholders, while retaining a guarantee on depositors.]

Munchau goes on to say that: “We know from economic history that countries enter into longish phases of stagnation after a financial crisis.

[My estimates based on the IMF and OECD models of fiscal and financial crisis imply that Ireland can expect at least another 33 quarters of continued crisis pressures in Exchequer finances, house prices and asset markets, as well as a permanent decline in the potential rate of economic growth to below 1.5%]

Ireland suffered an extreme crisis. In the light of what we know, the safe assumption to make for Ireland – and Greece – is that there will not be much nominal growth in the next five years. If you make that assumption, you realise Greece will almost certainly not be in a position to repay its debts. While Ireland’s situation is marginally better, there are justified doubts about the country’s long-term solvency.”

[The above are not some idle words. They are, as I mentioned early, fully in line with the existent econometric models of crises based on historical experiences in the advanced economies in the past.]

Per Munchau: “….In Ireland, the cure would consist of nationalisation and wiping out the bondholders of Irish banks through bond-to-equity conversions.”

[Needless to say, since April 2008 I am on the record – in the press, media, on this blog, in public meetings and private briefings to the policymakers – these are exactly the first steps that need to be taken in order to begin – note, just to begin – the process of restoring order to our banking system. Irony has it – on a number of occasions, I have written to the Financial Times precisely about these issues, raised by Mr Munchau, with, needless to say, not a peep back from the broadsheet offices].

Economics 13/9/10: Our crises are more than academic

This is an unedited version of my article in the Irish Mail on Sunday.

Adjoining the famed Moscow Conservatory there is a trendy Vieneese-styled café set in a quiet side-street of a bustling city center. Kofemania is a little microcosm of today’s young and upwardly mobile Moscow. On a late night break from the week of the Irish Trade Mission here, I was meeting a group of friends. Half a dozen of us, from different walks of life, crammed into a small booth were having a lengthy chat about life in general and our futures in particular. In our late 30s-early 40’s, one way or another, we can all relate to the topics of our children and our own and their futures.

For the first time in my life, I found myself being a deeper pessimist in the company of my Russian friends.

Like its Irish counterpart, Russian economy had a tough couple of years since the global financial crisis hit the country in the second quarter of 2008. However, amidst the crisis Russia has managed to deploy significant economic reforms – financed by a prudent fiscal policy during the boom. Their austerity programmes are offset by tax cuts, disposals of state assets and continued capital stimulus.

Since the beginning of 2010, the country economy has expanded at approximately 5% annual rate of growth, despite enduring the worst drought and wildfires in over 200 years. Moscow is enjoying a robust revival: city economy is up some 8% in real annualized terms since January this year, the local authority no longer runs a deficit and capital investment programme was underpinned just two days ago with a robust 12-yea bond placement for ca €500mln yielding less than Irish Government debt, despite being denominated in rubles. People are spending, taking holidays abroad, buying cars, and are genuinely almost over the “recession gloom” when it comes to their outlook for the future. There is even a pick in investment in second homes in Spain and France taking place as a friend of mine, running a specialty real estate agency has told me. Tight credit conditions during the crisis are easing gradually, but steadily and not a single of my friends has switched their banks accounts to foreign intermediaries or altered the mix of currencies they hold - a sure bet that they do not expect significant pressure on the ruble or a ramp up in inflation that currently runs modest (by Russian standards) 5.5-5.7%.

My fiends are fully convinced that their lives are going to be just fine and their kids future will only get better. The generational game of renewal and raising of expectations – the hallmark of any society that enjoys a sense of confidence in its future – is well underway in Moscow.


It's a different story for us in Ireland.

This week’s admission by Alan Dukes, that the bank’s final expected loans losses can top €39 billion became the final straw for many people here, as well as for myself. Follow up admissions by the Government that the fiscal reforms of quangoes, promised back in 2008, are not happening made it clear that the policy path we are taking hardly amounts to much more than a waiting game in a hope for a miracle of the externally driven turnaround.

Over a year ago, I publicly estimated that the total losses in the Anglo will reach up to €38.6 billion. My total estimate of the net losses in Irish banking crisis since March 2009 has remained around €50-53 billion. There’s little to be gained from having gotten the estimates right. The sheer extent of the economic destruction that befell Ireland over the last three years is now hitting my own home, hard.

A third year into an economic equivalent of the Perfect Storm, the reality of our economic collapse remains unchanged. Worse – the storm, using Bertie Ahern’s turn of phrase, is only getting stormier.


All in, the combination of banking and fiscal hell we are currently living through will exact an economic toll unseen by this country since the age of the Famine. Courtesy of the consistent and persistent policy failures spanning the last decade and continuing to-date, my own family, like a million other ordinary taxpayers’ families in Ireland have been turned into an army of serfs bound by the state to the rapidly sinking Titanic of our banking and fiscal policies. The very hope of seeing my children living in a world of higher social and economic standards – that cornerstone of any family raison d’etre – is now under a real threat.

Within the last 12 months, the new wave of unemployment is wiping clean the ranks of professional, highly educated younger services sectors workers. The social mobility ladder that provides hope for our and our children future has collapsed.

Tens of thousands of students are now actively seeking to emigrate out of Ireland. Five years ago, less than one in ten in my Trinity classrooms intended to go abroad in search of starting careers. This summer, the number rose to about three quarters. By my estimates, over 200,000 people have left this island in the last 24 months and some 300,000 more are on the verge of emigrating, held back by the shackles of negative equity and rapidly rising debt.

For our middle class, just as for my own children, education was supposed to be a sure bet for achieving a steady progression to economic and social well being. Today, this is no longer the case.


Both myself and my wife hold advanced post-graduate degrees and have achieved above average careers with over 15 years of steady growth. Yet, back in the Autumn of 2008 both of us have almost simultaneously lost our main jobs. Four subsequent months, spent living in the hell of uncertainty, were some of the toughest periods we ever endured. Throughout these months, the fear for the future backed by our steadily declining savings was compounded by the complete absence of any leadership from our policymakers.

This fear still remains a part of our daily lives. Hope for a recovery today is contrasted by the vacuous and occasionally outright insulting statements from high podia about imminent ‘turnarounds’ and ‘patriotism’, and the ‘hard choices’ allegedly being made the country leadership that is painfully unable and patently unwilling to make any real decisions.


The crisis we face is not a temporary, but a structural one. In order to unwind a roughly 700,000 strong-army of surplus workers who are out work or grossly under-employed, Ireland will have to more than triple our entire exporting sector – a feat that even during the Celtic Tiger era would have taken some 25 years to achieve.

By the time my children finish their education, some 20 years from now, our family will have spent over two decades in a state of perpetual struggle to pay for the legacy of our banking sector collapse and fiscal policy fiascos, to cover the costs of bankers and bond holders bailouts and to unwind a massive pile of private and public debts accumulated through the erroneous and egregious policies we have pursued since 2001-2002.


To finance ever-increasing social welfare and public sector pay bills, a family like ours will be pushed into massively higher taxes on income, property and everyday necessities.

The numbers are frightening. Frightening to the point of getting me worried about even my own family ability to endure this crisis.

Nama and banks rescues alone will add some €110,000-120,000 to our family debt pile through state-accumulated liabilities. Property and assets collapses in the end will contribute another loss of €300,000 to our net worth. The benefits of free education and children-related allowances will be gone, implying a life-time loss of roughly €120,000 for our family. At current yields, the debt accumulated through the deeply flawed banks recapitalizations and Nama, plus egregious current spending deficits will impose an annual interest bill of €12,000-15,000 on our family by 2014. Interest on the state debt alone will cost us every year the same as our children’s education.

American philosopher and writer, Ayn Rand once said that: “It only stands to reason that where there's sacrifice, there's someone collecting the sacrificial offerings. Where there's service, there is someone being served. The man who speaks to you of sacrifice is speaking of slaves and masters, and intends to be the master.” Recall Minister Lenihan’s statements about the need for ‘patriotism’ in his two Budget 2009 speeches. With the events transpiring around us today, Rand’s words are now no longer a catchy turn of a phrase.

Our pensions – supported solely by our personal savings – will be a shadow of their current expected value as funds returns will remain stagnant over the years of painfully slow growth, caused by the disastrous policy choices. Inflation, imported from the rest of the Eurozone, will mean that the real value of our savings will be declining over time.

Our healthy demographics – normally a reason for optimism in economic future – can end up driving this economy deeper into slow growth scenario. By the time my children will be finishing their university degrees, today’s middle-age workers will see their pension ages extended in order to reduce the exchequer pensions liabilities. This means that twin peaks of new job markets entrants between 2020 and 2030, Irish workforce will swell with educated, but inexperienced professionals unable to locate a job because their retirement age parents have no option but to continue working into their seventies.

This scary trend is well underpinned by today’s reality, including that of my own household. Save for a sizeable mortgage, our family is completely debt-free for the moment. Myself and my wife have good private sector jobs and earn well above the average family income. On the paper – we are doing fine.

Our future liabilities are massive, courtesy of the Government mismanagement of fiscal balances since 2003, the Croke Park deal, the Social Partnership-led pillaging of the growth years, the banks rescues, Nama and the chronic lack of real reforms in the state-controlled sectors.

Banks bailouts are already having a direct effect on our family. Amidst historically low interest rates, our mortgage has grown throughout 2010 and is likely to rise even more comes 2011, just as the negative equity continues to bite deeper and deeper into our ‘investment’ which value has shrunk roughly 40% since the time we bought into it. By my estimates, the spreads between the ECB base rate and the average variable rate mortgage charges will rise from 2.5-3% today to 4% by the end of the next year. After that, the ECB will start hiking its rates, with a distinct possibility of our mortgage finance costs more than doubling within a span of 15 months.


As an economist, I am all too familiar with the long term nature of the fiscal, house prices and banking crises that were are experiencing today.

Based on what we know about fiscal crises, our debt to GDP ratio will peak at over 125-130% around 2015-2017. At these levels, any economy, even a highly competitive one, would suffer a catastrophic decline in long term prospects for growth.

In the end, Ayn Rand was right – the sacrifices and patriotism of our politicians’ speeches has turned the people of this country into serfs to the vested interests of Social Partnership and banks’ elites. They speak of a sacrifice, intending to be the masters. My family, and millions of other ordinary people around this country are now just meaningless pawns in their game for survival.

Economics 6/9/10: Summer of missed opportunities

This is an unedited version of my column in the current edition of Business & Finance magazine.


To those of us who practice economics in the real world of markets and private enterprises, the homo economicus is a species endowed with the picture of the past but a vision of the future. To academics, economic reasoning is almost exclusively descriptive. This difference is not about the power or accuracy of forecasts. No one, familiar with the field would ever vouch in economists ability to deliver reliably accurate and useful predictions of specific outcomes.

Last few weeks offer a somewhat unusual, quasi-experimental insight into the future for Ireland Inc. July and August are the doldrums months in the giant global markets. Whatever happens around these months in Ireland, therefore, says more about our own capabilities and failures than what takes place in the rushed days of September and October.

So here is a picture of Ireland, then, in the Petri dish of our own policies.

Courtesy of the independent analysts first, followed by the IMF’s July report, we have learned that Irish Government deficit is doing the opposite of what the Government has hoped. Department of Finance projections for 2010 pencilled in 11.6% borrowing requirement for the Exchequer. May forecasts by the independents was for a figure ‘closer to 20%’. IMF July prediction is 19.9%. And that is before the latest spill of Anglo and INBS ‘bad’ loans news.

Overall tax receipts are now running €1,536mln below 2009 numbers for the first seven months of this year, and are still way off 2008 numbers by €5,520mln on 2008. This means we are now 8.22% below 2009 and 24.35% on 2008. Vat is €483mln or 6.9% below 2009, and €2,453mln or 27.5% behind 2008. And this is after the massive Vat boost from automotive sales increases driven predominantly by the vanity 2010 plates. Income tax shows a similar pattern: down €537mln on 2009 (-8.45%) and €1,060 on 2008 (-15.4%).


On the expenditure side, savage cuts to capital investment account for virtually all ‘savings’ achieved to date. This is fine, were the Government to undertake significant reforms in the current spending in the forthcoming Budget. However, all indications are that it will not do anything of the sorts.

The Machiavellian Croke Park deal enshrined in stone the very structure of pay and employment practices that makes up for one third of our gargantuan public spending bill. We even had a veritable drama performance befitting Abbey from the ICTU/SIPTU/CPSU leaders who worked tirelessly to ‘sell’ the deal to their members. The end result was the complete shedding of public sector liabilities onto the shoulders of ordinary taxpayers.

Social welfare reforms can at the very best be minimal in the current climate of chronic and continuously rising unemployment. In addition, timing of Liver Register increases suggests that many of the unemployed are close to exhausting their job seekers’ benefits and redundancy payments, pushing them deeper into the welfare trap. Add to this the fact that de facto the ruling coalition has no political capital left to fight its corner on a deep reform, and you have only one conclusion to make about the next Budget: prepare for savage tax increases all ye who hold a job!

This signal to the rest of the world and our own entrepreneurs and the workers in the productive (i.e. exporting) sectors is inescapable. Pro-business Ireland will hike your taxes to make you pay for the ‘industrial peace’ achieved in the public sector wards.

And it is highly unlikely that such policies can lead any significant stabilization of the Exchequer finances at any rate. Tax increases have been significant since the beginning of the crisis, yet tax revenues continue to decline. The fabled ‘stabilization’ across some tax heads to-date has been nothing more than the slowdown in the rate of tax receipts decline. There is no tax receipts uptick. Meanwhile, expenditure side remains worryingly sticky. The end game here is that the IMF (and even our own stockbrokerages – not exactly the paragons of critical assessment of the Government’s official position) are now predicting 2015 deficit to remain at ca 5.3% of GDP, more than 1.8 times the size of the deficit we promised to deliver to the EU Commission back in December 2009.

To put even more sparkle into Ireland Inc’s already shining portrait of competitiveness, the semi states are now desperately searching for any possible ways to beef up their revenues. Electricity costs went up to support such environmentally insane practices as drainage of bogs and burning of peat. As Richard Toll of ESRI summarised one side of Minister Ryan’s policy Bermuda Triangle – we are dumping a massive subsidy to producers of some of the most polluting energy the mankind can have. Transport costs are continuing to rise. All state-controlled sectors continue to show positive inflation through the entire crisis.


The other two sides of the said triangle are equally internecine. Firstly, hiking energy costs – one of the most frequently cited obstacle to our cost competitiveness – during a recession is equivalent to an economic sabotage. Secondly, the only real beneficiaries of this scheme will be semi-state companies, where ‘jobs creation’ costs multiples of what it costs in functional exporting sectors. In other words, given the ESB average rates of pay and value added in this economy, spending €85 million that latest price hikes will net the company in straight subsidies can ‘create’ roughly 3 times fewer jobs than using the same funds to support, say, a new pharma or IT firm entry into this market.

In the mean time, Irish banking sector continued to take on water. Losses in AIB and Bank of Ireland came to cumulative €3.9billion in the latter and a whooping €2bn in just six months for the former. Within days after their respective H1 2010 results announcements, both banks were exposed as having underreported their true loss by a cumulative €817 million thanks to a timing loophole. Anglo and INBS popped their ugly heads out of the somnambulistic slumber to ask taxpayers for €1.9 billion more in funds. Hence, within a span of just 4 months (post March banks pledges made by Minister Lenihan), Irish taxpayers were presented with more than €2.7 billion in new liabilities. At this rate, banks demands on our cash, that Messrs Cowen, Lenihan and, now, Honohan claim to be ‘one-off’ measures, will be running at an annualized rate of €8 billion – or over 26% of our entire 2010 tax take forecast by the Department of Finance.

All of the Ireland’s six state-guaranteed banking institutions remain firmly behind the reality curve when it comes to provision for future losses. Something that the Government appears to accept without a challenge, suggesting that instead of being an active large shareholder (and in the Anglo and INBS cases – the sole shareholder), our state is just letting the banks go on with the business of denying the obvious. Even the stockbrokers at this stage have stopped covering the banks with deeper analytical notes, resorting instead to a quick overview of the interim announcements.

Looking at independent analysis, through the cycle losses in banking institutions are expected to total €50-53 billion in total. This implies additional losses in the system of ca €22-25 billion, split between Anglo further losses of €9-12 billion, INBS losses of additional €2-2.3 billion, AIB further demand for capital in excess of already pre-announced to the tune of €8 billion, Bank of Ireland’s additional €2 billion and EBS €1 billion.

These estimates are based on the balancesheet analysis performed by the banking expert, Peter Mathews and my own modelling using past property and asset markets busts in the OECD, plus updated information from Nama and banks’ own results. The fact that the two estimates virtually converge by institution and in the aggregate gives us more comfort that they are closer to reality than the ‘hit-and-run’ numbers being produced by the banks and official analysts.

All in, my prediction is that Ireland’s state and quasi-state (e.g. Nama) debt pile will grow to over €210 billion by 2014, which puts into perspective the latest ‘successful’ auction of Irish bonds. At the yields achieved, financed with benchmark 10 year bonds, the debt accumulated through the deeply flawed banks recapitalizations and Nama, plus egregious current spending deficits will impose an annual interest bill of €11,310 million our economy. That’s right – by 2014 we are risking paying out more than 33% of our entire 2009 tax revenues in interest charges on the debt.

Adding insult to the injury, the Government has passed every opportunity presented to it so far to impose meaningful reforms on Irish banks. The latest missed opportunity came with the extension of the banking guarantees through December 31, 2010.

At the point of granting this measure to the banks – this time around absent the duress of an immediate crisis – Minister Lenihan could have simply required the banks to adopt deep changes in their operational models and strategies. Such a list could have included the following Nine Steps Reform Plan:

1. Require banks to negotiate significant haircuts on subordinated and senior bond holders, including debt for equity swaps. Time frame – 3 months;
2. Require banks to prepare detailed equity issuance proposals. Time frame – 1 month
3. Require banks to prepare binding estimates of expected future losses through 2012 (3 months) which can serve as a benchmark for board performance on annual basis going forward;
4. Require banks to reform their boards and board members reimbursement to be tied into long term performance by the bank (3 months);
5. Require banks to create independent strategy, risk and operations oversight and advisory committees with the power of direct reporting to the Boards and external strategy and risk audits of the annual results (3 months);
6. Require the banks to commit to a full root and branch reform of upper management (3 months);
7. Force banks to accept salaries and bonus caps on all senior management and board members (1 month);
8. Require banks to achieve conversion of existent outstanding mortgages to a tracker rate of euribor plus 225 bps (allowing the banks a ca 140-155 bps margin on all loans) whenever such a conversion is requested by the mortgage holder (6 months);
9. Actively engage in the process of renegotiating mortgage contracts terms (e.g. maturity and payment schedules) with distressed households, under direct oversight of the Financial Services Ombudsman

At the time of public debate concerning the Guarantee extension, I made the above proposal public and brought it to the attention of several senior members of the ruling coalition. Despite this, and despite a clear cut need for deep reforms of the banks operations and strategies, Minister Lenihan simply opted to walk away from using another opportunity to change the way Irish banks are run.


All in, the summer of 2010 has proven to be a season of missed opportunities and foregone reforms. Whether in academic, or in practical economic analysis terms, this sets the stage for only one outcome to the rest of the year. Instead of engaging pro-actively in building the future of this economy, our leaders have taken to a role of being passive observers on a sinking Titanic of domestic non-exporting economy. The cost of this inaction is likely to manifest itself through a Japan-styled long term recession and a rising burden of the state and its clientele (the banks and semi-states-dominated sectors) on the society at large.

Economics 2/9/10: Exchequer results - expenditure

So if there was no miracle happening on the receipts side, what was Minister Lenihan having in mind while drumming about the improvements in the fiscal position? Perhaps it was a dramatic turnaround on the Exchequer spending side?

Let's take a look at the year on year performance across all departments (2 charts below):
Looks like all departments are performing well in cutting back spending, save for Social Welfare and the department of Communications, Energy and Natural Resources. However, even a cursory glance suggests that something is amiss. In particular, it is pretty clear that the cuts are primarily happening on the capital side.

What the above charts do not tell us is that there is an interesting dynamic structure emerging to the cuts. This is highlighted in the next chart:
Notice the following in the chart above:

• Capital spending cuts overall have clearly dominated current spending cuts - for example, in August the ratio of capital spending cuts to current spending cuts stood at -34% for the former and -1.6% for the latter;
• Capital spending cuts are finally starting to decline in magnitude, having peaked in June at 36% and having declined to -34% in August. It looks like the state is finally beginning to spend - though still anemically - on the few capital projects it promised to deliver this year.
• Current spending cuts became shallower and shallower as the year progressed. In January 2010 current spending was 11.9% below the same period of 2009. In 5 months to May it fell to -5% compared to 5 months to May 2009. In August it is down only 1.6% on the same period of 2009.

Predictably, cuts in the net cumulative voted expenditure are also getting shallower and shallower:
So far we are down 5.8% on 2009. But this is not exactly a massive achievement, given the trends underlying cuts to date.

Another problem is that given the Croke Park agreement, there is a clear reason as to why the current spending cuts are getting weaker.

Either way - just as with receipts, I am not seeing any improvements anywhere in these numbers. If anything - Government spending is way too slow to adjust and is adjusting so far in a wrong direction.

Economics 2/9/10: Exchequer results - tax receipts

So folks, with some trepidation - given the ambitious statements concerning yet another 'turnings of the corner' by Minister Lenihan in today's 'Voice of the Irish Civil Services Gazette' (err... commonly known as The Irish Times) - I awaited the August Exchequer results.

The surprise, I must say, is all my, at least on the tax take side. Things have improved... dramatically... by what I would described as a 'nil change'. In other words, there is no improvement on the tax side.
Total tax take is now moving deeper down relative to 2009 and is nowhere near 'turning around'. It is not even stabilizing on the downward trajectory. Year-on-year total tax take is down 9%. End of July the same figure was 8.2%. Oops...

Income tax and Vat two mega tax heads:
The two are 8.2% and 6.4% behind January-August figures for 2009. A slight improvement on the gap in 7 months to July (8.4% and 6.9% respectively), but not that much of an improvement.

Corporate and excise taxes:
Corporate tax take is now on a trend of erasing the surplus on 2008 accumulated since June. This is bad, folks. In 7 months to July 2010, corporate tax receipts were 13.8% behind 2009 figure. In 8 months to August 2010 these are a massive 24.1% behind. As far as excise tax goes - receipts in 7 months to July 2010 were -3.3% behind corresponding period for 2009, by August 2010 8-months cumulative receipts gap to 2009 period shrunk to 2.7%. Good weather and more partying at home (instead of taking vacations) means booze is being consumed, while euro weakness relative to 2009 means we are buying more of it at home instead of N Ireland.

Next the 'Celtic Tiger Taxes', aka Stamps:
No sign of a serious improvement on abysmal 2009 here either. Poor showing continues with receipts down 18.2% on 2009 in seven months to July and down 11.1% on the first 8 months of the year in August. Let's see what happens in the big boost month of September.

Capital gains:
CGT was down on 2009 in the first 7 months of the year by 44.1% and down on the first 8 months of the year by 42.6%. Marginal gain in relative performance is clearly not enough to bring us even close to the extremely poor performance of 2009.

Summarizing year on year changes in all tax heads:
And to entertain our 'official analysts' favorite pass time: performance relative to targets
One noticeable and real change in monthly returns is the share of the burden that befalls our ordinary incomes:
Table below summarizes:
Nothing really to add to this except this: Minister Lenihan clearly thinks we are seeing improvements on the fiscal side. I see continuously increasing burden of Minister Lenihan's deficits on the ordinary taxpayers and consumers. In my economics books, this is bound to add pressure on Irish growth. Severe pressure.

Economics 1/9/10: Live Register

Live Register came in with no surprise - a moderate increase in the calm of August was so predictable, my forecast for unemployment to reach 13.8% in August made back in May came in bang on.

Here are few charts and some analysis.
Per chart above, seasonally adjusted LR rose from 452,500 in July to 455,000 in August, an increase of 2,500. Added cost to the Exchequer - ca €63mln per annum. Added cost to the economy - 2.5 times that. Added cost to the society - much greater than the latter. Added cost to those who lost their jobs and their families - incalculably high.

So far, year on year to August 2010 there was an unadjusted increase in the Live Register of
30,198 (+6.9%). This compares with an increase of 34,403 (+8.0%) in the year to July 2010. Now, that doesn't look like a stabilization to me.

There was an increase of 700 males and 1,900 females in the seasonally adjusted series in August. Which means services are tanking faster than manufacturing.

The average net weekly increase in the seasonally adjusted series in August 2010 was 625, which compares with a weekly increase of 1,700 in the previous month. Chart below illustrates
Both monthly and weekly increases are now below 6 months moving average lines, both of which are still trending up. Momentum suggests moderate mean reversion in September/October. Which brings us to unemployment levels.
Standardised unemployment rate in August was 13.8%, and all indications are it will continue to rise.

Finally, charting the changes together:

My suggestion that latest breakdown between men and women joining LR shows jobs destruction in services sectors is supported by the CSO analysis of detailed data.

Overall,

• Craft and related (25.5%) was the largest occupational group on the Live Register in August,
  
• Plant and machine operatives (15.4%) second largest, followed by
  
• Personal and protection service (10.7%) and
  
• Clerical and secretarial (10.7%).
  

Six of the nine occupational groups showed monthly Live Register increases in August:

• Largest percentage increase was in the Professional group (+1.2%)

In the six months to August 2010 Professional (+26.8%) group also showed the largest increase, followed by Clerical and secretarial (+14.6%) and Sales (+ 11.9%). The smallest percentage increase was in the Managers and administrators group (+1.0%).

Per CSO: "There were increases in six of the nine occupational groups in the six months to August for males on the Live Register. The largest percentage increase was in the Associate, professional and technical group (+12.0%), with the largest decreases in the Managers and administrators and Personal and protective service groups (both -0.8%). For females there were increases in all occupational groups in the six months to August 2010. The largest percentage increase was in the Professional group (+43.3%) followed by the Other occupation group (+25.8%)."

Live Register duration also rose, for males and females in 6 months to August 2010, suggesting severe pressures in the jobs market continue.

Of greater interest will bee changes in the labor force participation - to be shown in QNHS results. I suspect we will see severe contraction in overall number of people working or seeking work in the country.

Economics 1/9/10: Retail Sales

Today's retail sales figures continue to provide the backdrop to my previous analysis of the Irish economy as the one still facing strong headwinds and showing no real signs of a recovery. After months of 'turning the corner' statements (by now clearly deserving to be serialized in The Simpsons or perhaps in the Sponge Bob) and the drone of the ESRI data on 'consumer confidence' improvements, people still continue to vote by withdrawing their spending.

Here are the charts and the results.

Overall volume of retail sales (i.e. ex-price effects or ex-deflation that is ruining retail sector jobs that is) contracted 0.1% yoy in July 2010. There was a monthly decrease of 0.2% - steeper than the annual decrease. We now have 3 months of continued declines.

Ex-Motor Trades the volume of retail sales shrunk by an impressive 2.5% in July 2010 yoy and -1.0% mom. Year-on-year and mom volumes rose in Motors, Fuel and Food, and decreases in everything else.

Stop for a second and think. Volume is just the bulk of stuff we buy. If the retail sector were to stop losing jobs and start growing again, increased volumes of sales (not that we have them anyhow, but give it a thought nonetheless) must be accompanied by non-falling value of sales.
Oops... the value of retail sales collapsed by 3.2% in July 2010 yoy and fell -0.6% mom. Ex-Motor Trades things were even worse: sales values fell 4.9% yoy and -0.6% mom. In fact, per CSo own admission: "only Motor Trades and Fuel showed year-on-year value increases in July 2010. All other sectors showed year-on-year declines in the value of retail sales" And boy these declines were rather large:

• Non Specialised Stores (-1.5%)
• Department Stores (-7.3%)
• Pharmaceutical Medical & Cosmetics (-10.6%)
• Clothing, Footwear and Textiles (-5.7%)
• Other Retail (-8.8%)
• Bars (-13.8%)
  

In mom terms, Motor Trades, Non-Specialised Stores and Electrical Goods showed increases in
the value of retail sales in July 2010. All other sectors showed mom value decreases in July 2010.

Now, these are not the results of 'improving consumer confidence' are they?

Overall, retails sales suggest that Q2 consumer spending will be a likely positive contributor for GDP growth, but Q3 will do the opposite. Of course, there is a catch here - the RSI data covers only sales of goods, but not of services, yet consumption expenditure on the latter accounts for 55% of the total consumption spending. Indications are - based on Live Register results showing contraction in services employment - services sales might be even weaker. Another sign of hidden weaknesses is in the ex-Motors sales. Ex-Motor volumes posted Q1 growth of 1.2%, followed by a preliminary estimate of 1.1% growth in Q2. The latter has been now revised down to a miserly 0.3% for Q2. Since then, ex-motor sales have been falling in both July and August.