Economics 19/9/10: Irish banks - Government intervention still has no effect

Returning to my old theme - let's take a fresh look at the Government and its policy cheerleaders success rate with repairing our banking sector. Here is a quick snapshot of history and numbers as told through the lens of Irish Financials index.
So clearly, we have some really powerful analysts out there and keen commentariat (actually one and the same in this case) on the future prognosis for our banks.

But what about recent moves in the index itself?
Take a look at the chart above, which maps the Financials Index for two subperiods:
Period 1: from Guarantee to March announcement of the 'final' recapitalization of our banks,
Period 2: from Guarantee to today.
Now notice the difference between two equations. That's right, things are not getting any better, they are getting worse.

Next, let's put some historical markers on the map:
Surely, our financials are getting better, the Government will say, by... err... not getting much, much worse. The reality, of course is, any index has a natural lower bound of zero. In the case of Irish Financials Index, this bound is above zero, as the index contains companies that are not banks. As far as the banks go, there is a natural lower limit for their share values of zero. Our IFIN index is now at 80% loss relative not to its peak, but to its value on the day of Guarantee!

Having pledged banks supports to the tune of 1/3 of our GDP already, the Government policy still has not achieved any appreciable improvement in the index.

Forget longer term stuff - even relative to Q4 2009, Government policies cannot correct the strategic switchback away from Irish banks shares that took hold:
A picture, is worth a 1000 words. Unless you belong to the upbeat cheerleaders group of the very same analysts who missed the largest market collapse in history, that is.

Economics 19/9/10: What's human capital got to do with our policies?

Having spent last week giving three presentations in Ireland on our IBV paper (link here) concerning the role of human capital in urban and regional development, and having spent a week before given another five presentations/briefings on the same topic in Russia, I should probably take a break from the topic.

So here is a quick note: I finally came about to read an interesting study from McKinsey & Co on the importance of talent as a driver of competition between firms, published back in February 2008. It is a very insightful piece.

Here's an interesting quote, referring to two McKinsey Quarterly global surveys (emphasis is mine). "The first, in 2006, indicated that the respondents regarded finding talented people as likely to be the single most important managerial preoccupation for the rest of this decade. The second, conducted in November 2007, revealed that nearly half of the respondents expect intensifying competition for talent—and the increasingly global nature of that competition—to have a major effect on their companies over the next five years. No other global trend was considered nearly as significant."

Furthermore, "Three external factors—demographic change, globalization, and the rise of the knowledge worker—are forcing organizations to take talent more seriously."

Amazingly, there is little evidence to-date that policymakers have any idea the process of global competition for talent is underway in their economies. With exception of the US and Switzerland, every OECD economy puts the heaviest burden of taxation onto shoulders of the very same talent for which companies in these countries compete.

Ireland is the case study here. After a decade and a half of aggressively incentivising foreign investment into the country (not a bad thing in my books), Irish leadership has left human capital - and especially internationally mobile human capital - bearing more than 3/4 of the total tax burden in the country. Now, this proportion is rapidly increasing (see chart), having risen from 75.31% in Q2 2007 to 80.42% in Q2 2010.
This process is accelerating per table below:
Unbeknown to our policymakers (it appears), labour, especially skilled labour in the sectors the Government promotes as the future of Ireland Inc (e.g. the 'knowledge' economy) is the largest cost input for firms. Yet, through the crisis, the Government has elected a two-path approach to resolving our fiscal difficulties:

• massive cuts in capital investment, and
• disturbingly high increases in income tax burden and other tax burden on disposable income by households.

Anyone to spot a contradiction here?

Economics 18/9/10: It's not just IMF

As argued in my earlier post (here), based on the IMF analysis, our sovereign bonds yields are still some distance away from those justified by fundamentals.

It turns out the IMF paper cited in the earlier post is not alone in the gloomy assessment of our realities. Another August 2010 study from German CESIfo (CESIfo Working Paper 3155), titled "Long-run Determinants of Sovereign Yields" and authored by António Afonso Christophe Rault throws some interesting light on the same topic, while using distinct econometric methodology and data from that deployed in IMF paper.

Here are some insights from the paper (available for free at SSRN-id1660368). "For the period 1973-2008 [the study] consider the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Sweden, Spain, UK, Canada, Japan, and U.S."

Take a look at table 2 of results from the paper estimation across listed countries. The model is based on 3 variables here - Inflation (P), Current Account (CA) and Debt Ratio (DR). All have predictable effect on the variable being explained. Per study authors: "Results in Table 2 show that real sovereign yields are statistically and positively affected by changes in the debt ratio in 12 countries. Inflation has a statistically significant negative effect on real long-term interest rates in ten cases. Since improvements in the external balance reduce real sovereign yields in ten countries, the deterioration of current account balances may signal a widening gap between savings and investment, pushing long-term interest rates upwards."

Ok, here are those results:
Ireland clearly shows relatively weak sensitivity in interest rates to debt.

But take a look on our sensitivity to deficits. Per study: "Moreover, when the budget balance ratio is used (Table 3) a better fiscal balance reduces the real sovereign yields in almost all countries"
Clearly, Ireland shows 3rd highest sensitivity of interest rates to Government deficits. We are in the PIIGS group, folks, based on 1973-2008 data!

Now, this firmly falls alongside the IMF results - further confirming my guesstimate in the post earlier.

Economics 18/9/10: IMF data on bond yields

With all the debate, recently fueled by the Governor of our Central Bank and Minister for Finance, concerning the level of Irish bond yields, it is always insightful to look at the historic evidence as the source of better understanding of the underlying bond markets realities.

Fortunately, courtesy of the IMF, there is some new evidence on this issue available. IMF working paper, WP/10/184, titled "Fiscal Deficits, Public Debt, and Sovereign Bond Yields" by Emanuele Baldacci and Manmohan S. Kumar (August 2010) does superb analysis "of the impact of fiscal deficits and public debt on long-term interest rates during 1980–2008, taking into account a wide range of country-specific factors, for a panel of 31 advanced and emerging market economies."

In a summary, the paper "finds that higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. Taking into account these factors suggests that large fiscal deficits and public debts are likely to put substantial upward pressures on sovereign bond yields in many advanced economies over the medium term."

But the detailed reading is required to see the following: "the impact of fiscal balances on real yields provided results that were quite similar to the baseline, although the size of the estimated coefficients was larger: an increase in the fiscal deficit of 1 percent of GDP was seen to raise real yields by about 30–34 basis points." (Emphasis is mine). Table below provides estimates:
By the above numbers, Irish bonds currently should be yielding over 7.54%. Not 6.5% we've seen so far, but 7.54%. This puts into perspective the statements about 'ridiculously high' yields being observed today.

If we toss into this relationship the effect of change in our public debt position, plus a risk premium over Germany (note that the estimates refer to the average for countries that include not just Ireland, but 29 other developed economies, including US, Germany, Japan and so on), the expected historically-justified yield on our 10 year bonds will rise to

• deficit-induced 7.54% +
  
• country risk premium driven by deterioration in economic growth adjusting for ECB rates) of 1.46%+
• change from initial public debt position 0.30%

So the total, fundamentals-justified Irish 10 year bond yield should be around 9.30%.

Don't believe me? Well here's a historic plot that reflects not a wishful thinking of our policymakers, but the reality of what has transpired in the markets over almost 30 years.
Ooops... looks like our ex-banks deficits warrant the yields well above 10% and on average closer to 15%, nominal (remember the above yields computed based on model results are real). Alternatively, for our bond yields to be justified at 6.5% we need to cut our deficit back to around 5.2% mark and hold our debt to GDP ratio steady.

Someone, quick, show this stuff to our bonds 'gurus' in the Government.

Economics 17/9/10: Busting some myths on CEOs compensation

Another fascinating paper that I came across last night trolling through old files.

Published by FEEM as a working Paper 89, 2010, titled “Executive Compensation: Facts” it was authored by Gian Luca Clementi and Thomas S. Cooley of NYU and NBER. The link to the paper is here.

In this paper the authors look at the executive compensation in the US from 1993 to 2006.

Per paper: “Notable facts are that: the compensation distribution is highly skewed; each year, a sizeable fraction of chief executives lose money; the use of security grants has increased over time; the income accruing to CEOs from the sale of stock increased; regardless of the measure we adopt, compensation responds strongly to innovations in shareholder wealth; measured as dollar changes in compensation, incentives have strengthened over time, measured as percentage changes in wealth, they have not changed in any appreciable way.”

Given hysteria around the world about executive compensation and commonly held views that:

• Executive compensation is getting more and more generous over time
• Executive compensation is now more unrelated to firm performance over time
• Executive compensation improving generosity is divorce from shareholder wealth

the study findings are enlightening.

The Clementi-Cooley study looks at a comprehensive measure of compensation – a combination of “salary, bonus, the year-on-year change in the value of stock and option holdings, the net revenue from the sale of stock and exercise of options, and the value of newly awarded securities.”

The study does some basic stats. For example, in contrast to the Trade Unions’ claims that the average US executive compensation for larger corporations was $10.8mln in 2006, the study shows that due to a significant skew in the data, the average metric is meaningless. The median compensation for the largest corporate executives in the US therefore, was much smaller (although still substantial) at $4.85mln.

The study also reflects on the well understood, but rarely cited fact that due to significant share of compensation of CEOs being in the form of stock and stock options, in many years, many CEOs actually experience losses in terms of their overall compensation, not gains.

The study is certainly worth reading as it contains factual analysis unencumbered by ideological bull usually found in the media.

Economics 17/9/10: Free markets are good for human capital

World Bank Policy Research Working Paper 5405, titled “Economic Freedom, Human Rights, and the Returns to Human Capital: An Evaluation of the Schultz Hypothesis” by Elizabeth M. King, Claudio E. Montenegro and Peter F. Orazem published in August 2010 is a very insightful read into the role of proper market institutions and rights in economic development. Paper link here.

T.W. Schultz postulated, back in 1975, an important hypothesis for why returns to schooling might vary across different markets. According to Schultz, human capital is most valuable when individual workers face unexpected price, productivity or technology shocks that require managerial decisions to reallocate time and resources.

In other words, in Schultz’s view, human capital acts as a hedge against such uncertainty. If skilled individuals are not exposed to shocks that require resource allocation decisions or if they are denied the freedom to make those decisions, then they will not be able to capture the economic returns from their skills.

It stands as a logic corollary that if a country imposes economic or political institutions that cushion the shocks or hinder individual economic choice, then we should observe lower returns to skill in countries that limit exposure and/or individual responses to uncertainty.

In the case, relevant to Ireland, this logic extends not only to traditional factors, such as:

• Degree of labour force unionization
• Extent of social welfare safety net
• Existence of the minimum wage laws
• Restrictions on mobility into public sector jobs and protected professions jobs
• Structures of pay and promotion divorced from productivity considerations
• Visa restrictions

and other buffers, but also more novel factors such as

• Negative equity
• Housing markets access restrictions (e.g. birth-right to development of homes in some areas)
• Cultural restrictions (e.g. Gaeltacht)
  
• Lack of credit supply, etc

Per World Bank study cited above:

“A cursory inspection of the data yields support for the hypothesis. … [dividing] data from 86 developing countries into three groups based on their relative ranking in the Heritage Foundation’s Economic Freedom Index, with 25% each placed in the least and most free economies and the rest being placed in the middle. … Private returns to schooling for the freest economies average 9.7% per year of schooling, 3 percentage points higher than the average returns in the most restrictive economies. Returns for the middle group fall between the two extreme groups. [The authors] repeat the exercise … for private returns to years of potential experience. Again, average returns are highest in countries rated as the most economically free (5%) versus the middle (4.7%) and least free (4.2%) countries. These results are broadly consistent with the proposition that freer economic institutions raise individual returns to human capital.”

Furthermore:

“T. P. Schultz (1998) found that about 70% of the income inequality in the world is due to country-specific fixed effects that would include the impacts of country-specific political and economic institutions on earnings. Acemoglu and Robinson (2005) argued that these institutions were formed in response to exogenous influences existing at the time of a country’s founding, and that these institutions tend to persist across generations. [World Banks study] use measures of economic and political institutions to determine if they can alter returns to human capital across countries sufficiently to explain some of the persistent cross-country income inequality reported by T. P. Schultz. [The study found] that, consistent with the T.W. Schultz hypothesis, human capital is significantly more valuable in countries with greater economic freedom. Furthermore, the positive effect is observed at all wage quantiles. Economic freedom benefits the most skilled who get higher returns to schooling; but it also benefits the least skilled who get higher returns from experience.”

Now, this has three basic implications for Ireland.

Firstly, the study results show that higher human capital returns (in other words greater incentives to invest in human capital) are associated with less restrictive labour market policies, greater extent of basic human rights protection, more pluralist system of social organization and lesser emphasis on equalization of outcomes in economic environment. In other words, market wins, crony capitalism (Irish model) and socialism (Swedish model) lose.

Secondly, the study also implies that if Ireland were to be focused on developing a viable knowledge economy (aka human capital-intensive economy), the country needs more market, more freedom, less protectionism and lower restrictions in the labour market.

Thirdly, the study suggests that environments with lower tax burden on labour and lower Government/State interference in private activities are more likely to produce better human capital base.

Instead of farcical Mr Top Hat Kapitalist, it looks like free markets and societies benefit Ms Advance Degree Holder.