4/5/2012: Direct democracy and fiscal profligacy

Here's a very interesting study on the effects of direct democracy rules on the size of government. The paper: "Does Direct Democracy Reduce the Size of Government? New Evidence from Historical Data, 1890-2000", published in the Economic Journal, vol 121, issue 557, pages 1252-1280, 2011, but available free as an earlier draft working paper here, sets out to estimate the effect of direct democracy institutions on the size of government expenditure. The study uses Swiss cantons asa the 'test-bed' for direct democracy.

The study shows that once fixed effects are deployed to control for unobserved heterogeneity, and once instrumental variables are used to control for potential endogeneity, direct democracy can be linked to imposing constraints on cantonal spending. However, the overall impact of direct democracy on curtailing public spending is much more modest than previously suggested.

Thus: "a mandatory budget referendum reduces canton expenditures by 12%. Lowering signature requirements for the voter initiative by 1% reduces canton spending by 0.4-1.4%. We find little evidence that direct democracy at the canton level results in higher local spending or decentralization.


Update:


And another very interesting case study on effects of direct democracy, in this case - the study of Icelandic Constitutional change in the wake and in response to the crisis:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2034241

4/5/2012: Fitch Bells: Ringing de Panic?

Yesterday, Fitch Ratings issued an interesting report, titled "The Future of the Eurozone: Alternative Scenarios". The report sounds alarm bells over what some markets participants have thought of as a 'past issue' - the risks of contagion from Greece to the Euro area periphery.

Fitch Ratings core view is that the eurozone will 'muddle through' the crisis, surviving in its current composition,  while taking 'gradual steps towards closer fiscal and economic integration'. 


The interesting bit comes in the discussion of possible alternatives and the associated probabilities of these alternatives. According to Fitch, there is rising (not falling, as we would expect were LTROs and Greek debt restructuring, plus the Fiscal Compact and the ESM working) risk of a protracted growth slowdown or political shock or some other shock triggering either a possible facilitated Greek exit from the Euro or a disorderly Greek exit from the common currency.


And, crucially, according to Fitch, this risk cannot be discounted. 


This bit is where Fitch's assessment is identical to mine and contradicts that of the majority of Irish 'green jersey' economists: the tail risk of a disorderly unwinding of the euro is non-zero and rising, while the disruption or cost associated with such a outcome is by far non-trivial. Prudent risk management policy would require us to start contingency planning and addressing the possible realisation of such a risk. Instead, we are preoccupied in navel gazing through the lens of the Fiscal Compact, and not even at our own 'navel', but at the European one.


Fitch view is that a full break-up and demise of the euro is probabilistically highly unlikely. This belief is based on Fitch foreseeing large financial, economic and political costs of a break-up. More interestingly, Fitch determines that a partial break-up of the euro zone - with one or more countries exiting the common currency -  would "risk severe systemic damage, although cannot be discounted". 


For those thinking we've done much to resolve the systemic euro crisis (by doing much we usually mean creation of EFSF and agreeing ESM, deploying LTROs and restructuring Greek debts, and putting in place the Fiscal Compact), Fitch has some nasty surprises. Basically, Fitch believes (and I agree with their assessment here), that "additional measures will be needed to resolve the crisis. These are likely to include some dilution of national fiscal sovereignty [beyond the current austerity programmes and Fiscal Compact], potentially some partial mutualisation of sovereign liabilities [basically - euro bonds of sorts] and resources [some transfers to peripheral states], as well as measures to enhance pan-eurozone financial supervision and intervention, combined with further institutional reforms to strengthen eurozone economic governance". Basically, you can read this as: little done, much much much more to do still...


It gets worse.


Of all the alternative scenarios presented, Fitch believes that the most likely scenario will involve a Greek exit, with Greece re-denominating its debt in a new currency and default on its bonds again. Per Fitch, the core danger will be to Cyprus, Ireland, Italy, Portugal and Spain based on:

1. Greek exit creating an 'exit precedent' for the already distressed economies
2. Greek default impacting adversely other peripheral countries banks (especially true for Cyprus)
3. Greek default increasing the risk of capital flight from the countries
4. Greek default triggering a run on peripheral bonds just around the time when the 2013 'return to markets' horizon is in the crosshair.

Just as I usually do in my presentations on the topic, Fitch distinguishes two potential paths to Greek 'exit' - a structured and unstructured or 

• an "orderly variation with an effective eurozone policy response and minimal contagion" and 
• a "disorderly variation", involving "material contagion to the periphery and a significant increase in contingent liabilities facing the core".

Ouch, I must say, for all the folks who lost their voice arguing that my views are 'unreasonable' and 'scaremongering'. Sorry to say it, risk management approach to dealing with reality requires taking a probabilistically-weighted expected costs scenarios of the downside into the account. Simply shouting "all is sustainable here, nothing to bother with" won't do.

4/5/2012: Sunday Times - 29/4/2012: Fiscal Compact

My Sunday Times article from April 29, 2012 (unedited version).

When first published, the Fiscal Compact (formally known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) was billed as a ground-breaking exercise in European legislative activism. The main innovation of the treaty was not its content (which largely regurgitates already existent fiscal constraints established under the Maastricht Treaty), but its compact size and designed-to-be-digestible language.

Few months down the road, and the Fiscal Compact has become a subject to numerous conflicting claims and interpretations, thanks to both side of the referendum debate in Ireland. Mythology that surrounds the Fiscal Compact is impressively wide and growing. The fog of politicised sloganeering and scaremongering on the ‘Yes’ side is well matched by the clouds of emotive and quasi-economic nonsense from the ‘No’ camp.

The main alleged problem with the Compact is that its core rules – the 60% debt/GDP limit for Government borrowings, the 1/20 adjustment rule for dealing with excess public debt, the 3% deficit ceiling and the 0.5% structural deficit break – amount to prohibiting of the Keynesian economic policies in the future. This argument is commonly advanced by the Fiscal Compact opponents and implies that in the future crises, Ireland will not be able to use stimulative Government spending to support its economy.

In practice, however, Fiscal Compact restricts, but not eliminates the room for deficit financing. In the current economic conditions, under full compliance with the deficit rules, Irish Government would have been able to run a deficit of at least 2.97% of GDP – much lower than 8.6% targeted under Budget 2012, but close to 3.2% deficit forecast for 2012 for the euro area.

Far from ‘killing Keynesianism’, the Fiscal Compact induces in the longer run fiscal policies that are consistent with Keynesian economics. Any state that wants to secure a ‘fiscal stimulus’ cushion for future crises should accumulate surplus resources during the times of economic expansions, not rely on the goodwill of the bond markets to supply debt financing to the Governments when their economies begin to tank.

The treaty does limit significantly the state capacity to accumulate debt in the future. In the long run, debt to GDP ratio should converge to the ratio of average deficits to the long-term growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Fiscal Pact-consistent government deficits around 1.6-1.7% of GDP. Assuming long-term nominal growth of 4-4.5% per annum, our ‘sustainable’ level of debt should be around 36-40% of GDP. Although no one expects (or requires) Ireland to draw down our public debt to these levels any time soon, over decades, this is the level we will be heading toward if we are to comply with the Fiscal Compact rules.

On the ‘Yes’ side, the biggest myth concerning the Fiscal Compact is that adopting the treaty will ensure that no more fiscal crises the likes of which we have experienced since 2008 will befall this state.

In reality, the collapse of exchequer finances in Ireland has been driven by a number of factors, completely outside the matters covered by the Fiscal Compact.

Firstly, significant proportion of our 2008-2011 deficits arises from the state response to the banking sector implosion and closely correlated property sector collapse. The latter was also a primary driver for the decline in tax revenues. The former was a policy choice. Thirdly, our deficits were driven not just by the fiscal performance itself, but also by the unsustainable nature of our government spending and taxation policies. For example, during the boom, Irish Governments consistently acted to increase automatic payments relating to unemployment and social welfare financed on the back of tax revenues windfall from property transactions. Property revenues collapse coincident with increases in unemployment has led to an explosion of unfunded state liabilities.

None of these shocks could have been offset or compensated for by the Fiscal Compact-mandated measures. In fact, during the 2000-2007 period, Irish Governments’ fiscal stance, on the surface, was well ahead of the Fiscal Compact requirements. Ireland satisfied EU Fiscal Compact bound on structural deficits in all years between 2000 and 2007, with exception of two. Of course, in all but one year over the same period, we also failed to satisfy the very same bound if we were to use the IMF-estimated structural deficits in place of those estimated by the EU, but that simply attests to the difficulty of pinning down the exact value of the potential GDP, required to estimate structural deficits. We also satisfied EU-mandated debt break in every year between 2000 and 2008. In fact, between 2000 and 2007 our debt to GDP ratio was below 40% - the benchmark consistent with long-term compliance with the Fiscal Compact. More than fulfilling the requirement for a 3% maximum Government deficit, Irish Exchequer run an average annual net surplus of 1.97% of GDP, accumulating 2000-2007 period surpluses of €11.3 billion and the NPRF reserves which peaked in Q3 2007 at €21.3 billion.

In short, the Fiscal Compact is not a panacea to our current crisis, nor is it a prevention tool capable of automatically correcting future imbalances, especially given the difficulty of forecasting future sources of risk.

Instead, Ireland needs a combination of institutional reforms to enhance our domestic capacity to identify points of rising risks and to deploy policies that can address these risks in advance. A flexible and highly responsive early warning system, such as a truly independent Fiscal Advisory Council, coupled with reformed Civil Service, aiming at achieving real excellence and accountability within the key Departments and regulatory offices can help. Furthermore, abandonment of the consensus-focused systems of governance, eliminating the expenditure-centric Social Partnership and the Dail whip system, and reformed legislative and executive systems to increase the robustness of the checks and balances on local and central authorities, are needed to develop capacity to respond to emerging future crises. Legal reforms, to address the imbalances of power of the vested groups, such as bondholders or state monopolists, vis-à-vis the taxpayers, are required to prevent future bailouts of private and semi-state enterprises at the expense of the Exchequer. Local authorities reforms are required to ensure that the madness of over-development and land speculation do not build up to a systemic crisis. Taxation reforms are needed to stabilize future revenues and develop an economically sustainable tax system.

The Fiscal Compact is a wrong policy for all of the above because it risks creating a confidence trap, which can replace or displace other reforms. It represents a wrong set of objectives, as it diverts state attention from considering the nature of underlying imbalances. It also re-directs much of the fiscal responsibility away from Irish authorities, potentially amplifying the reality gap between the real economy and the decision-makers. By endlessly blaming Europe for tying Government’s hands, the Compact will continue building up voters’ perception disenfranchisement, fueling stronger local political orientation toward parochialism and narrow interests representation, while alienating voters from European institutions.

In short, the Compact is not an end to the politics as usual. This, perhaps, explains why no independent analyst or politician is prepared to vote in favour of the new Treaty except under the threat of the Blackmail Clause contained not in the Fiscal Compact itself, but in the forthcoming ESM Treaty and which requires accession to the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union as a pre-condition for gaining access to the ESM funds. Not exactly a moment of glory for either Europe or Ireland.

  

Box-out:

By now, we have become accustomed to the endless repetition of the boisterous claims that the continued declines in Government bond yields since mid-2011 signal the return of the markets confidence in Ireland. Alas, based on the last two months worth of data, things are not exactly going swimmingly for this school of thought. Based on weekly data, Irish benchmark 9-year bond yields spreads over Germany have contracted sharply in year on year terms, falling on average 1.30 percentage points since March 1, 2012 and 1.26 percentage points in April. The former is the second best performance in the euro zone after Italy, and the latter marks the third best performance after Italy and Portugal. Alas, weekly changes have been much less impressive. Since March 1, our yields have actually risen, in weekly terms, with an average rate of increase of 0.02 percentage points. For the month of April, the same metric stands at 0.05 percentage points. The same performance pressure on Ireland is building up in the Credit Default Swaps markets, with our 5 year benchmark CDS spreads declining just 0.24 percentage points compared to Portugal’s 5.2 percentage points drop since a month ago. Overall, European CDS and sovereign bonds markets are now signalling the exhaustion of the positive momentum from the December 2011 and February 2012 LTROs. Ireland’s bonds and CDS are no exception to this rule, suggesting that the ‘special relationship’ that we allegedly enjoy with the markets might be now over.

4/5/2012: Irish Examiner 26/4/2012: Is there an alternative to austerity?

This an unedited version of my article that appeared in the Irish Examiner, April 26, 2012.

However one interprets the core parameters of the fiscal discipline to be imposed under the Fiscal Compact, several facts concerning the new treaty and Ireland’s position with respect to it are indisputable. Firstly, the new treaty will restrict the scope for future exchequer deficits. Combined structural and general deficit targets to be imposed imply a maximum deficit of 2.9-3.0 percent in 2012 as opposed to the IMF-projected general government net borrowing of 8.5% of GDP. Secondly, it will impose a severe long-term debt ceiling, but that condition will not be satisfied by Ireland any time before 2030 or even later.

At the same time, the Troika programme for fiscal adjustment that Ireland is currently adhering to implies a de facto satisfaction of the Fiscal Compact deficit bound after 2015, and non-fulfilment of the structural deficit rule any time between now and 2017. In other words, no matter how we spin it, in the foreseeable future, we will remain a fiscally rouge state, client of the Troika and its successor – the ESM.

Let me run though some hard numbers – all based on IMF latest forecasts. Even under the rather optimistic scenario, Ireland’s real GDP is expected to grow by an average of 2.27% in the period from 2012 through 2017. This is the highest forecast average rate of growth for the entire euro area excluding the Accession states (the EA12 states). And yet, this growth will not be enough to lift us out of the Sovereign debt trap. Averaging just 10.3% of GDP, our total investment in the economy will be the lowest of all EA12 states, while our gross national savings are expected to average just 13.2% of GDP, the second lowest in the EA12.

In short, our real economy will be bled dry by the debt overhang – a combination of the protracted deleveraging and debt servicing costs. It is the combination of the government debt and the unsustainable levels of households’ and corporate indebtedness that is cutting deep into our growth potential, not the austerity-driven reduction in public spending.

There is absolutely no evidence to support the suggestion that increasing the national debt beyond the current levels or that increasing dramatically tax burden on the general population – the two measures that would allow us to slow down the rate of reductions in public expenditure planned under the Troika deal – can support any appreciable economic expansion. The reason for this is simple. According to the data, smaller advanced economies with the average Government expenditure burden in the economy of ca 31-35% of GDP have expected growth rates of 3.5% per annum. Countries that have Government spending accounting for 40% and more of GDP have projected rates of growth closer to 1.5% per annum. Ireland neatly falls between the two groups of states both in terms of the Government burden and the economic growth rate.

Despite the already deep austerity, Irish Exchequer will continue running excess spending throughout the adjustment period. Between 2012 and 2017, Irish government net borrowing is expected to average 4.7% of GDP per annum, the second highest in the EA12 group of countries. Put differently, calling on the Government to deploy some sort of fiscal spending stimulus today is equivalent to asking a heart attack patient to run a marathon in the Olympics. Between this year and 2017, our Government will spend some €47.4 billion more than it will collect in taxes, even if the current austerity course continues. Of these, €39 billion of expenditure will go to finance structural deficits, implying a direct cyclical stimulus of more than €8.4 billion.

The exports-driven economy of Ireland simply cannot sustain even the austerity-consistent levels of Government spending. IMF projects that between 2012 and 2017 cumulative current account surpluses in Ireland will be €40 billion. This forecast implies that 2017 current account surplus for Ireland will be €10 billion – a level that is 56 times larger than our current account surplus in 2011. If we are to take a more moderate assumption of current account surpluses running around 2012-2013 projected levels through 2017, our Government deficits are likely to be closer to €53 billion.

In short, there is really no alternative to the austerity, folks, no matter how much we wish for this not to be the case.

Instead, what we do have is the choice of austerity policies to pursue. We can either continue to tax away incomes of the middle and upper-middle classes, or we cut deeper into public expenditure. The former will mean accelerating loss of productivity due to skills and talent outflows from the country, reduced entrepreneurship and starving the younger companies of investment, rising pressure on wages in skills-intensive occupations, while destroying future capacity of the middle-aged families to support themselves through retirement. The latter is the choice to continue reducing our imports-intensive domestic consumption and cutting the spending power of the public sector employees, while enacting deep structural reforms to increase value-for-money outputs in the state sectors. Both choices are painful and short-term recessionary, but only the latter one leads to future growth. The former choice is only consistent with giving vitamins to a cancer-ridden patient – sooner or later, the placebo effect of the ‘stimulus’ will fade, and the cancer of debt overhang will take over once again, with even greater vengeance.

26/4/2012: One interesting point on Fiscal Compact 1/20 rule

One interesting point on Fiscal Compact, folks. The 1/20th adjustment rule has been interpreted widely as the rule requiring states with debt/GDp ratio in excess of 60% to reduce their debt levels by 1/20th of the gap between their existent debt level and the 60% bound. However, the Treaty itself states: "the obligation for those Contracting Parties whose general government debt exceeds the 60 % reference value to reduce it at an average rate of one twentieth per year as a benchmark" (page T/SCG/en5). In other words, there is a big gap between interpretation and reality.

Hat-tip for this discovery goes to Peter Mathews, TD.

Say, Ireland's debt/GDP ratio peaks at 120% GDP (I am rounding up the actual forecasts here). Under 'interpreted' adjustment mechanism, we would be expected to reduce the overall debt by 1/20th of 120% minus 60% or by 3% of GDP in year one. Under the actual Treaty, we are expected to reduce it by 1/20th of 120% or 6% of GDP in year one. Say our GDP is 175 billion in that year. Under interpreted rule, we have to find €5.25 billion to reduce debt levels, under actual Treaty language, we are expected to come up with €10.5 billion. To put this into perspective, the average level of gross investment in the Irish economy is forecast by the IMF to be around 10%pa between 2012 and 2017 or ca €17.5 billion under above assumptions. This means that the Fiscal Compact adjustment path would take out 60 percent of the entire annual investment in the economy. That is hardly a chop-change of a difference.


Updated: Thanks to Prof Karl Whelan for pointing this:

Applying the 1/20^th to the full amount is not consistent with the Treaty.

Article 4 ...makes reference to  “as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No. 1177/2011 of 8 November 2011”

And Regulation 1177/2011 states: “When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available.”

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:306:0033:0040:EN:PDF

So it’s the gap to 60%.

26/4/2012: Sunday Times 22 April 2012: Water and Property Taxes

Here's my Sunday Times article from April 22, 2012 (unedited version, as usual):

Years ago, I quipped that Ireland doesn’t do evidence-based policies, instead we do policies-based evidence. Current whirlwind of taxation initiatives is the case in point. These include the household charge and its planned successor a property tax, plus the water charge and its twin meter installation charge. These policy instruments are poorly structured, rushed in nature, and are not based on hard economic analysis.

Water is a scarce resource, even in Ireland. On the supply side, we have abundant water resources in some locations and bottlenecks where population concentrations are the highest and where the bulk of our economic activity takes place. Reallocation of water to reflect demand/supply imbalances is a political issue, and creation of a monopolized system of water provision is not an answer to this. More effective would be to encourage local authorities to sell surplus water into a unified distribution system. Coupled with a structural reform and consolidation of the local authorities, this approach will incentivise productive economic activity in water-rich, less developed regions and provide competitive pricing of water.

Water delivery infrastructure is free of political constraints, but faces huge capital investment and operational problems. These factors are determined by treatment and transmission systems, and water quality monitoring capacity in the system. Chronic underinvestment in these areas means that Ireland’s quality of water supply is poor and water losses within the system are staggeringly high. Delivering this investment is not necessarily best served by a centralized monopoly of water provision. Only pipe infrastructure should be a monopoly asset, charging the transit fee that will reflect capital investment and maintenance needs of the system. Treatment and part of monitoring network can be retained at the local level to provide for local jobs and income.

Water charges are the best tool for demand management, a system of incentives to conserve water at the household and business level, as well as the revenue raising to sustain water infrastructure. In this context, a water charge is the best policy tool.

Currently, we pay for residential water via general taxation. If the policy objective is to improve water supply systems and create more sustainable demand, water charges should replace existent tax expenditure. In addition, higher level of collections is warranted to allow for investment uplift. Current price tag is estimated around €1.2 billion. Of these, ca €200 million come from business rates which feature a low level of compliance. Assuming half the normal rate of M&A efficiencies from consolidating the system of local water authorities, factoring in a 50% uplift on businesses rates compliance and allowing for a 25% investment buffer, annual revenues from residential water supply system should be around €900-950 million. This is the target for revenues and at least 1/3 of this target should go to reduce the overall burden of income taxation.

To deliver on the above target, we can either conceive a Byzantine, and thus open to abuse and mismanagement, system of differential allowances, rates and exemptions. Alternatively, we can take the existent volume of residential water demand and extract from this current price per litre of water. This rate should allow a 10-15% surcharge to incentivise future water conservation and to finance investment in water supply networks. Use this system for 3 to 5 years transition period. Thereafter, the market between the local authorities will set the price.

The charge, should apply to all households consuming publicly-supplied water. For poor households who cannot afford the charge, means-tested social welfare payments should be increased to cover water allowance based on the family size and characteristics. Savings generated by some households should be left in their budgets. The resulting system will be ‘equitable’, and economically and environmentally sustainable.

A complicated pricing structure of exemptions and allowances, backed by a quango and a state water monopoly, will not deliver on any the above objectives.

A different thinking is also needed when it comes to structuring a property tax. The latest instalment in the on-going debate on this matter is contained in the ESRI report published this week. In the nutshell, the ESRI report does two things. First, it proposes an annual tax on the value of the property while applying exemptions for those with incomes below specific thresholds. Second, the ESRI report attacks the idea of a site value tax as being infeasible.

Both points lead to an economically worst-case outcome of a property tax that falls most heavily on younger highly indebted families, thus replicating the distortionary effects of the already highly progressive income tax.

An economically effective system of property or site-value taxes should be universal, covering all types of property and land, regardless of ability to pay. Why? Because a property or a site value tax offers the means for capturing the benefits of public amenities and infrastructure that accrue to private owners. These benefits accrue regardless of the households’ ability to pay. Low-income household facing an undue hardship in paying the rates can be allowed to roll up their tax liability until the time when the property is sold.

My own recent research clearly shows that a site value tax imposed on all types of land, including agricultural and public land, represents a more economically efficient and transparent means for capturing private gains from public investments. It is also the least economically distortionary compared to all other forms of property taxation. This is so because a land value tax increases incentives for most efficient use of land and decreases incentives to hoard land for speculative purposes. A traditional property tax, in line with that proposed by the ESRI, does the opposite.

With a deferral of tax liability for those unable to pay, a land value tax will bring into the tax net those who hold significant land banks and/or own large parcel properties, but who are not investing in these lands and are not using them efficiently. The system will allow older households to retain their homes, but will charge fair fees on the property value that has nothing to do with these households own efforts when the gains are realized either at sale or in the process of inheritance.

The ESRI argument against implementing a site value tax is that the lack of data and a small number of land transactions in the economy prevent proper valuation. This argument is an excuse to arrive at the desired conclusion of infeasibility of the site value tax. Ireland is starting property valuation system virtually from scratch. Thus, unlike other countries, we have the luxury of doing it right from the start. Compiling a database for land valuations is easier than for property valuations precisely because sites have much less heterogeneity than the properties that occupy these sites. In simple terms, value of property is determined by the value of buildings located on it, plus the value of the site. The former is much harder to value than the latter. The value of a specific site can be backed easily out of an average or representative value of the properties located within the vicinity of the site, plus by referencing directly specific attributes of the site.

As with the water charges, the property tax system must be designed not from the premise that the Government needs a quick hit-and-run revenue fix, but from the premise that we need a new approach to taxation. Such an approach should aim to reduce the burden of taxation that penalises skills, work effort, entrepreneurship and discourages households from investing in their own human capital and properties. Instead, the burden of taxation should be shifted on paying for specific benefits received and on privately accruing gains from public investments and amenities. In this context – both water charges and a property or a site value tax represent a step in the right direction. But to be effective, these policies must be structured right.

Charts:

Box-out:

Just when you thought the taxpayers can breath easier when it comes to the banks, the latest data from the Irish, Spanish and Italian authorities shows that the banks of the European ‘periphery’ have dramatically ramped up their holdings of their countries’ Government bonds. In 3 months through February 2012, Irish banks increased their holdings of Government bonds by 21%, Spanish – by 26%, Italian – by 31%. Back in late 2008 I warned that the banking crisis will go from the stage where sovereign debt increases will be required to sustain zombified banking systems, to the stage when the banks will be used as tools for financing over-indebted sovereigns, to the final stage when the weak nations’ sovereign debt will become fully concentrated within the banking systems they have nationalized. Sadly, this prediction is now becoming a reality. As GIPS’ banks increased their risk exposures to the Governments that underwrite them, German and French banks have been aggressively deleveraging out of the riskiest sovereign bonds. In Q1 2012, Portugal ranked as the second most risky Sovereign debtor in the world in CMA Global Sovereign Credit Risk Report, Ireland ranked seventh and Spain ranked tenth, with Greece de-listed from the ratings due to its recent default. This concentration of risk on already sick balancesheets of the largely insolvent banks is a problem that can reignite the Eurozone banking crisis.