Economics 05/02/2010: Prepare for a new slide

Fasten your seat belts and prepare for a new round of bad news. Globally this time around.

All data for January-February is showing that the pressures of jobless recoveries around the world, coupled with continued weaknesses in financial sector and money supply (despite unprecedented stimulus deployment and helicopter drops - more like blanket bombings - of liquidity) are over-powering the weak positive momentum in growth.


December retail season was, officially, a disappointment – down 1.6% on 2008 season across the euro area. The headline Eurozone Manufacturing PMI reached 52.4 in January, highest reading for two years. The index stood at 51.6 in December, so the rise was marginal.

There were noticeable disparities in performance between national manufacturing economies. Countries reporting an increase in output were Germany, France, Italy, Austria and the Netherlands. All improved on December. Spain, Ireland and Greece all recorded lower output and faster rates of contraction.

Sector data indicated that capital and intermediate goods fared best in January. Growth consumer goods production is falling below that achieved in the previous month.

Growth of new orders was the strongest since June 2007 and faster than the earlier flash estimate. The gain in the index between its flash and final releases was the greatest since flash PMI data were first compiled at the start of 2006. New export orders rose at an above flash estimate pace that was the quickest since August 2007. See Ireland PMI in my Sunday Times article this week.

Despite rise in core PMI, manufacturing continued to shed jobs during January, across the Eurozone.

Core retail sales (ex-motors) in Germany were weaker in November than previously reported (down 1.7% mom) but rose 0.8% mom in December. Car sales are down 40% quarter on quarter –driven by the end of the scrappage scheme. Which, of course, shows that Irish experiment with temporary programmes of subsidies is unlikely to work. Interestingly, in Germany, scrappage scheme has benefited primarily foreign manufacturers. Of course, the reason for this is that German car makers are primarily at the top of the price proposition distribution and in a recession, subsidy or none, they will suffer. Foreign care makers sales rose 26% in December and 38% in January, before the scrappage scheme shut down. Domestic car sales were flat.

Sign of troubles ahead for exports growth – German manufacturing orders are down 2.3% in December while output contracted 2.6%.

Greece and Portugal are clearly in the news flow. Both have no market credibility when it comes to their deficits. And the reports from the ground are even worse with virtually all vox-pop reporting suggesting that populations of both countries are in deep denial of the reality. People are talking about ‘fat cat managers earning hundreds of thousand euros’ while ‘ordinary people are suffering’. Long legacy of communist and socialist politics in both countries is clearly evident in the popular unwillingness to face the music.

The next points of pressure will be Ireland and Spain.

On Ireland’s fiscal position and PMIs – read my Sunday Times article this weekend.

On Spain: the country is about 3 times bigger in economic terms than Greece and Portugal – accounting for roughly 11.8% of the euro area GDP. Troubles here will be a much bigger problem for the Eurozone than all the rest of the PIIGS (less Italy) combined. Meanwhile, Spain’s unemployment is rising (just as Ireland's), adding some 125,000 to the dole counts in January. 19% of Spaniards are now officially unemployed, as opposed to Ireland’s 12.7%. In terms of hidden unemployment, Spains problems are also much tougher than Ireland’s especially since grey markets for construction workers which sustained unofficial employment during the boom are now shut in Spain.


Credit is still tight in the euro area and the FX valuations are still around $/€1.36 – way too high for an exports recovery.

It is now painfully clear that the only thing that can resolve euro area’s problem would be a massive one-off emission of liquidity directly into the government budgets. To do this, the ECB can set a target of, say, €1,000 per capita for the eurozone economies, disbursed to each country based on their population. Anything else simply won’t do.

But even such a measure will not provide sufficient support for Greece, Portugal, Ireland and Spain – only a temporary reprieve.


UK’s economy is also in stagnation pattern with full-time employment still falling, individual, insolvencies up to record highs. The uptick in house prices in late 2009 is likely to have been temporary and driven by speculative ‘testing the water’ by international investors. Manufacturing PMI is up robustly January to 56.7, its highest level since October 1994, and from 54.6 in December. The increase was driven by new orders, which rose at the fastest pace in six years, as well as companies' efforts to clear backlogs of existent orders. It remains to be seen if this pace of improvements is sustainable. Services sector PMI meanwhile contracted rapidly from 56.8 in December to 54.5 in January, marking the slowest activity in five months.

Here is a little fact to put things into perspective – manufacturing accounts for less than 20% of the UK economy, while services account for 76%.


Overall, this recovery is coming along with more stress and strain on the labour markets. All global indicators are now appearing to have peaked back in Q4 2009, with the new year starting on downward trajectory. Inventory cuts passed in previous quarters are now being worked out and there is little sign this process will be picked up by a structural increase in new orders. All in, jobs growth is now severely lagging that achieved in the end of the previous recessions. In this environment, growth favours the US where jobs cuts were much more significant and early, allowing firms to rebuild their margins before the onset of any demand improvements. Eurozone is, in contrast, toast. Indicative of this is the volume of global trade – with Baltic Dry Goods index down to 2704 today as contrasted by 3335 reading 3 months ago.


Strategically – I would short Europe as an index, but look for low cost medium margin operations for a long position.

Economics 04/02/2010: McKinsey gets banal with risk

Latest McKinsey Quarterly (here) contains an article on global risks. Sub-titled "Top risk forecasters highlight their picks for this year's economic and political hot spots", the article is short and... really, really, really banal.

Here it is in its full glory (emphasis is mine):

Where will the greatest risks — known and unknown — flare up on the global business landscape this year? In this roundup, three prominent forecasters scan the horizon. [Notice the use of the future tense, forward-looking language]

...Economist Intelligence Unit's latest global business risk assessment highlights ...growing political instability from rising global unemployment, macroeconomic risks as stimulus measures fade, and financial-system risk spreading to sovereign debt in Greece and other countries.

European fiscal divergence makes the list as well at the Eurasia Group, which also sees diminished appeal of economic partnership between China and the United States raising concern, while Iran faces growing pressure at home, regionally, and globally.

And the World Economic Forum's 2010 Global Risks report focused on, among other risks, the barriers to growth posed by structurally deficient or obsolete infrastructure, the spread of chronic disease, and illicit trade."

Let me re-list them:

• 'growing political instability from rising global unemployment' - hmmm, wasn't that already apparent in Greece back in December? or in Ireland during local and European elections? or in the US in the last Presidential elections? I can go on and on;
• 'macroeconomic risks as stimulus measures fade' - you don't need EIU's forecasting powers to spot that one - everyone trading in financial markets has been factoring it into valuation for months;
• 'financial-system risk spreading to sovereign debt in Greece and other countries' - now what's new here (given the last 15 months of erratic markets behavior and record bond issuance) is the 'financial-system risk spreading' bit. Which financial-system risk? It is a purely nonsensical statement, unless one means by it that the bond finance system itself is under threat (US Treasuries? German bunds?);
• The risk of 'European fiscal divergence' has been with us for some 5 years now and has been growing steadily;
• 'diminished appeal of economic partnership between China and the United States' - but, folks, 'economic partnership between the two is a traffic of investment from US into China in return of exports from China into the US. This 'partnership' was coming under pressure for decade now. It really started to unravel with undervaluation of yuan bearing on the dollar balance of trade in 2006-2007. Since then, the prospect of the 'diminished appeal' was pronounced in US politics, culminating in the last Presidential Campaign. President Obama has been promising a protectionist corporate tax system overhaul to 'diminish appeal' of investing in China for US MNCs since before his election. I wonder if this is really a risk for 2010;
• 'Iran faces growing pressure at home, regionally, and globally' - oh no, who could have guessed. Certainly 2009 elections - with violent clashes, murder of internal opposition leaders etc, all caught on TV news and broadcast around the world were not a sign of 'growing pressures at home'. And Russia moving alongside the US and Europe to attempt to curb Iranian nuclear ambitions (a process that started back in 2006) is also not a sign of 'growing pressures... regionally and globally'. In short - this 'prediction' is too - old news.

Only WEF actually returns some interesting (aka not-banal) risks - infrastructure constraint on growth is a good one (although there is an element of 'old news' here as well, as crumbling bridges in the US and collapsing new builds in Korea have been with us for almost 10 years now). WEF could have added to it the lack of Governments' capacity to find funding to repair this crumbling infrastructure as a new-ish constraint - post-crisis. They did not...

Illicit trade being on the rise? Predictable risk - in any recession, black markets grow.

But the pearl is the prediction of chronic diseases spreading in 2010. Of course 'chronic' refers to the rate of onset of disease and development being spread over longer time horizon (at least 3 months). So how would we know if chronic disease is spreading in the remaining 10 months of 2010? especially ones with gestation periods measured in years?

Precious stuff, really. Makes me want to create my own list of forward-looking risks for 2010 and beyond. It will start with something impactfull, like "Parts of the world will experience droughts while other parts will get flooded. Grey skies will cover Ireland on many occasions throughout 2010."

Any suggestions what else to include?

Economics 04/02/2010: Nama - riskier than Anglo?

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238.

As a proposition: I will use the study results to argue that Nama is a more risky undertaking than the Anglo Irish Bank.

Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures. Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);
• Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility.

To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either

• make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).

Of course, the problem with selecting the latter path way (collateral beefing up) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books.

Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”


What are the lessons for Nama from all of this? I am afraid not very positive ones. Nama is setting out to purchase loans on the basis of their collateral. Loans that are in distressed with collateral that has breached covenants due to precipitously declining valuations. Guess what – collateral risk is positively correlated with loans risk here from the start. Can this correlation be diversified? Yes, but not within Nama setting.

Remember, Nama promised to take good and bad loans together and mix them to derive cash flow. But these loans are all written against the same types of collateral as in:

• Same instruments;
• Same geography;
• Same vintages;
• Same currencies and so on.

In language of diversification – which loans returns are orthogonal to each other? Answer: none. Hence, no diversification is possible.

Take this back to the study findings and treat Nama as a sort-of-a-bank undertaking (with no deposits, but plenty of loans, although of course it does not matter, because Nama is not facing market funding constraints, courtesy of the state that is willing to give it your and my money with nothing definitive being asked in return).

Recall the last quote: “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.” But in Nama’s case – what borrowers with “lower credit risk” can they select? None.

This leaves only option for Nama – to raise the underlying quantity and quality of collateral. Again – can this be done?

Sure, if Nama can either increase seniority of its claims on the collateral, or if it can swap assets for higher quality assets somehow. Alas, this works in theory, but in practice, Nama is saddled with seniority and quality of assets that banks have. It cannot go out to the market and demand that senior debt holders out there step aside and let residual quality claims that Nama might hold to step forward. Nor can it go to the developers and demand that better or more collateral be pledged for the loans. It is neither legally possible, nor feasible, given the dire state of developers’ finances.

Now, step aside and think of the Anglo. Anglo is a bank that is saddled with exactly the same dilemma – poor loans risk diversification. Can it escape this conundrum, assuming it can get funding (remember – Nama has no funding constraint). Of course it can. It can diversify client base and start attracting clients with lower risk profile by offering cheap loans to selected clients. And of course, Anglo has done so in the past – perhaps not enough, but it did. It can go out and lend outside Ireland, to diversify via change of geographies (it has done so in the past as well). And it can load up on collateral – which, once again, Anglo did. And yet, despite doing all these things, Anglo collapsed.

Anyone still thinks Nama – with much more limited ability to diversify key risks – can succeed?

So here you have it – Nama is the ultimately non-diversifiable risk undertaking that is actually worse off in terms of risk profile than the Anglo Irish Bank…


One would hope their board and risk committee understand this. Not really - the board contains such experienced finance and risk people as town managers, and the risk committee - well, that one will be staffed by who knows who, for it will have no one from outside Nama on it.

And this, of course, is where Nama is so nicely reflective of the Anglo...

Economics 03/02/2010: Live Register for January

You've heard the numbers on Live Register results by now, no doubt. A summary, courtesy of CSO:
Here are few charts:
Having breached 430,000 marker this time around, the LR is back on the upward trajectory. As predicted. And with it - unemployment rate:
At 12.7%, we are now in December 1994 territory. Officially, all Celtic Tiger gains in terms of reduced unemployment are now gone. Some 14 years worth of hard labour gone within a span of just 21 months.

Oh, and in case you've heard that we are now doing soooo much better than in January 2009:
It is true - in January 2009, unadjusted LR was rising by 7,251 per week, this January it was rising by 'only' 2,668 per week. Yet, three things worth mentioning:

1. In January 2008 the rate of increases in LR was 2,768 per week - just 100 shy of January 2010;
2. This January saw the highest unadjusted increase per week since July 2009; and
3. Remember - the latest increases are ameliorated by two factors not present in previous years - already high unemployment (meaning that the number of jobs to be cut should be really declining) and high rate of workers outflow from the labour force.
   

Economics 03/02/2010: International hype around Ireland's Fiscal Policies

Nouriel Roubini - an economist I would regard extremely highly, writing today in the Financial Times (a paper I would regard extremely highly) clearly illustrates the point that to international observers, Ireland is hardly important enough to actually engage in fact-checking (here).

"The best course would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes and loophole closures that depend on historically weak compliance. ...This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 per cent."

Really? We haven't noticed. And neither did the Department of Finance.

First off - Irish fiscal adjustment to date is approximately 50:50 split between higher tax burden and spending savings.

Second, there has been no net reduction in public expenditure in Ireland since 2008. None, folks. Let's face the music performed for us by the Department for Finance. No spin from me. In its "Ireland – Stability Programme Update, December 2009" available to all (including Professor Roubini here) DofF provide some stats.

Start from the top: page 14 of SPU:
Clearly, no sign of decreasing expenditure in sight. Of course there are many reasons for this, but hey, where's that 20% cut? Or 1% cut? None through 2009.

But may be Prof Roubini is talking about future cuts of 20%? Ok, page 20 shows future expected expenditure figures per Budget 2010.
So clearly, neither Gross, nor Net current expenditure are set to fall from 2009 through 2014. Not on a single occasion.

On Capital expenditure side, there are severe cuts. So much is true. But a cut between 2009 and 2010 is just 10.7%, not 20%. The cut between 2009 and 2011 is 23.8% but that is only accounting for 3.11% of the total Net expenditure of the state in 2011. Where's that 20% cut in total expenditure coming from, folks?

DofF plans for a 2.8% cut in the General Government Balance in 2010, not a 20% cut either, and that will leave us (per their rosy forecasts on growth and tax revenue) at 11.6% deficit relative to GDP, down a whooping 0.1 percentage point on 11.7% deficit achieved in 2009.

Oh, yes, while Anglo Irish Bank transfers in 2009 (to the tune of €4 billion) enter the DofF estimates for General Government Balance, there are no provisions for the same anywhere in DofF projections for 2010 (see Table 1c, page 38). So pencil that in and you have No Reduction in Deficit in 2010! In fact, with banks supports still required, 2010 is likely to see an increase in deficits.

Take a look for yourselves:Notice that pesky number on borrowing requirement rising in 2010 on 2009? If Prof Roubini is correct, why would the Government that managed to cut its spending by 20% increase its borrowing by 3%? Unless the revenue side is expected to fall by more than 20%! But no, DofF expects total tax revenue to decline by 4.7% in 2010 (Table 1b, page 37).

Finally, Table 1d on page 40 shows that spending adjustments per Budget 2010 amount to the net of €-4,051,059. Of course, since then we have learned that some of the cuts will not be implemented, reducing this number to some €3.3 billion. But even at a higher level, estimated by the DofF, the adjustments add up to only 8.55% of the Net Voted Total Expenditure, or 6.42% of the Gross Total Expenditure in 2009.

Not even a half of Prof Roubini's 20%!

Hmmmm... someone has been fooled by the PR machine statements coming out of Dublin.

Economics 02/02/2010: NTMA and the banks

Per RTE Business (here which so far cannot be confirmed by any official material published on the NTMA website):

The NTMA "will now hold talks on capital needs with the institutions covered by the NAMA legislation. Among the other responsibilities it is assuming, the NTMA will also hold discussions with financial institutions on their realignment or restructuring within the banking sector. It will manage the Minister for Finance's shareholding in the banks, advise on banking matters, and crisis prevention, management and resolution."

Here are the interesting aspects of this change that raise a multitude of questions:

1. How will NTMA manage the conflict of interest between its own objectives per above and Nama objectives?
2. How will the potential conflicts of interest be disclosed to the markets?
3. What does it mean that NTMA will hold discussions with financial institutions? Will these discussions be subject to usual market disclosure rules or will they risk constituting a price fixing behavior?
   
4. How can NTMA's direct interference with the banks be compatible with the rights of other shareholders?
5. How will NTMA advising on banking matters etc play out vis-a-vis the roles of the Financial Regulator and the Central Bank?
6. What does 'crisis prevention, management and resolution' refer to? Systemic banking crises? Specific institutions crisis? Will it also include industrial relations crises? How will this process be carried out while respecting the general rules of disclosure and non-collusion with the market?
7. With massive firepower and own objectives, how NTMA will assure that the rights and interests of minority shareholders in the banks are protected?

In effect - even the mere raising of these questions implies that there is a risk that NTMA will be engaged in interfering with the markets for shares and debt in Irish banks in markets-distorting fashion. Amazingly we have no details as to how the Government and NTMA/Nama plan to avoid these problems.


There is another issue at hand here. If, at least in theory, DofF is a publicly accountable institution, NTMA by its statues is a secret entity (with extremely secretive culture to boot). What transparency can we, banks customers, have and what assurance can we hold that NTMA will not act to undermine or violate our rights, the safety of our deposits or our ability to access these?


Lastly, I am rather surprised at the timing of this change. In my view, this statement coming before Nama begins transfers of loans suggests that the Government is preparing for taking up a majority stake in the banks - a majority stake that will require full state control of these institutions management and activities.

So is this statement a precursor to full nationalization of the banks?

Economics 02/02/2010: Turning the corner

So we've turned the corner... err... our economy it is... only to discover that, behind that corner the same tumbleweeds keep on rolling across the Exchequer accounts.

It was worth a wait, folks, and January figures for Exchequer returns have shown that, as predicted, the deterioration in our public finances will continue despite Minister Lenihan's efforts in the Budget 2010.

A chart is worth a thousand words:
Tax receipts down on January 2009 by almost 18%. They were down 19% in January 2009 relative to January 2008. Spending, meanwhile, is down 7.5% on January 2009, but... there's always 'but': current expenditure is down by a much lower 5.59% and the slack is picked up by a whooping 21.1% decline in voted capital expenditure (the stuff that is supposed to provide stimulus to our economy through strong public investment programmes).
Check out monthly receipts above and spot the odd on - right, there has been an extraordinary increase of ca 50% (or 250 million) in January 2010 capital receipts. This, of course, is thanks to a massive hold-back on public investment programme in 2009.

What's going on?
Receipts side is clearly gone into a deep red - all, without an exception - lines of tax revenue have underperformed January 2009. Corporate tax has decreased to a third. Stamps - already miserable performer in 2009 are now 41% down on that. Capital gains also sunk by almost a quarter. Income tax, down a massive 9.72% is the best performer. This is dire, folks!

But expenditure side is also showing some poor performance:
Ok, I understand Social Welfare spending increasing 15.76% yoy, but agriculture? ETE is a mixed bag. But, get your thinking going. We are in a recession and in a third year of a fiscal crisis. Over the last two years, we have managed to reduce our spending by a miserable 6.9% or less than 3.4% annualized savings. And that was achieved with a Draconian Budget 2010. what will it take to cut our spending by 25-30% off the peak levels consistent with a structurally balanced budget?

Last picture...

But here is a different way of looking at the expenditure side:
Take the entire set of departments and divide them broadly speaking into primary (vital, if you want) and secondary (supportive) in terms of their roles. Guess which group has manged to achieve greater savings (in percentage terms) out of its budget?

Efficiently run Government would require the secondary set of departments to cut by at least 3-4 times the rate of cuts in the essential departments. Under the above, we'd have cuts of up to 60% in the total spending segment of €660million, or effective savings of €392 million more than has been achieved in one month, or roughly €1.8-2 billion in one year.

Not enough to decrease our massive deficit, but...

Economics 02/02/2010: Minimum Wage Blues

For those of you who missed my last Sunday Times article, here is an unedited version.

Last week, this newspaper reported about the successful Competition Authority probe into a price fixing cartel involving a number of car dealers. Of course, price fixing is illegal in Ireland. Illegal, that is, unless the perpetrator of it is the State. For proof, look no further than the price of unskilled labour – the minimum wage rate.

The end result of this law – a product of collusion between the Government and the Unions – is two-fold.

First, like any other collusive arrangement, the minimum wage leads to a long-term deterioration in the employment creation in the economy. Economists commonly link this to the deterioration in our overall competitiveness.

Second, minimum wage distorts incentives and choices of employers and employees. Over time, investment in skills, knowledge and aptitude fall for minimum wage recipients and lower-skilled, marginally more expensive employees, while businesses are incentivized to substitute their hours of work with physical capital. The age-old fear of machines displacing people is, thus, a logical denouement of the minimum wage.


The fact that the minimum wage laws reduce overall country competitiveness in the sectors heavily reliant on unskilled and low-skilled labour is undeniable. Ireland no longer registers meaningful contributions to its economy from mobile low-wage sectors. Only those lower skills activities that are captive by their nature – such as local protection services – remain here. However, the effects of the minimum wage on workers themselves are far less understood.

There is plenty of evidence that minimum wages lead to reduced employment of the lower-skilled and younger workers. Less known is the fact that minimum wage distorts education decisions of the young. Recent research from the Michigan State University shows that states that raised their minimum wage experienced increased unemployment amongst the low-skill teenagers who had previously dropped out of school. Higher-skill teenagers were more likely to get jobs, increasing their early exits from education. In other words, those who were best suited for early employment could not get a job, while those who were best suited for continued education were incentivised to drop out.

In the long run, minimum wage also shifts resources within various sectors of economic activity. Data for Ireland clearly shows that since introduction of the minimum wage here, traditionally labour-intensive sectors have seen their labour share of productivity decline, while capital share of value added has expanded. In some, labour productivity actually fell in absolute terms. These are the sectors, including hotel and restaurant services, construction, traditional manufacturing sectors, retail services and real estate activities and other, where minimum wage covers a larger overall proportion of the workforce. In contrast, other labour-intensive sectors, where wage structure was not dependent on minimum wage constraints, such as modern manufacturing, financial and professional services and wholesale and logistics services, have registered an above-average increase in overall share of value added attributable to skills and labour inputs. This trend, present in the data since introduction of the minimum wage, was not there prior to 2000.

And Ireland is hardly unique here. A study from the University of California recently showed that employers have reduced employment of the less skilled and increased employment of higher skilled workers with an emphasis on formal job training credentials in the wake of increases in minimum wage rates. For anyone concerned with the plight of the disadvantaged youths, these findings should ring the alarm bells.

Often, proponents of minimum wage laws argue that some studies have found little effect of the minimum wages on aggregate level unemployment. The problem, of course, is that such arguments neglect the issue of movement of people in and out of the labour force. While minimum wage hikes lead to higher average wages paid to those in employment, workers who lose their jobs often drop out of the labour force. As such, their numbers simply disappear off the unemployment count.

Hardly a right-wing liberal, Paul Samuelson, winner of the 1970 Nobel prize in economics had the following to say about the proposals to raise minimum wage: "What good does it do a …youth to know that an employer must pay him $2 an hour if the fact that he must be paid that amount is what keeps him from getting a job?"

This is a non-trivial observation, because it reveals one of the most damaging effects of the minimum wage laws in the modern economy. Nobel Prize winner Professor Gary S. Becker, suggested back in the 1970s that minimum wage acts as a dis-incentive for firms to invest in training of its lower-skilled employees. A recent pan-European study confirmed this to be the case across the EU, including Ireland.

The result of this is the creation of a two-tier economy, whereby those with no general and firm-specific skills remain at the very bottom of the economic hierarchy, while those with above-average skills are moving further and further up the skills chain. The companies, over time, respond to this separation by either choosing to invest more into machinery and technologies that can displace lower-skilled workers or by focusing their production processes on accumulating high quality staff.

This process drives the polarization of the overall Irish economy into what is known as ‘Modern’ and ‘Traditional’ sectors. It also drives deeper divisions amongst the lower-skilled and poorer workers by redistributing income within the lower earning segments of population. Some lower skilled get higher wages, others get permanent unemployment. In the US, a study by the National Bureau of Economic Research has shown that the 1997 hike in the federally mandated minimum wage has resulted in a 4.5 percent increase in the number of poor families.

But minimum wages do more damages than that. Generationally, it is the younger workers who tend to possess lower skills and have trouble signaling to the potential employers their latent abilities and aptitude. They also face higher unemployment rates, both at the times of growth and recession. For them, minimum wage laws create insurmountable barriers to escaping the twin trap of unskilled unemployment.

On the one hand, high minimum wage will increase the risk to the employer from hiring a wrong person, thus reducing the incentives to take on younger workers with unproven skills or performance records. On the other hand, the same workers need to gain access to positions which provide extensive on-the-job training in order to progress within the company. Even more importantly for the lower-skilled workers’ future, they need job environment that supports acquisition of generic skills and aptitude that can be transferred to other employers. Both of these investments are severely constrained by the presence of the minimum wage laws. The severity of this constraint is proportional to the gap between the minimum wage level and the average productivity of the workers seeking entry-level employment.

In other words, given the choice between hiring a young unskilled person for €8.65 per hour and a worker with more experience for the same rate, employers will always choose the latter. In times of robust growth, this might matter little, as other employment opportunities are abundant. Today, the picture is different.

Based on a comprehensive survey of minimum wage studies in the US, a 10 percent increase in the minimum wage tends to reduce employment of young workers by 1-2 percent during the times of abundant jobs creation. It is safe to assume that the rate is double in the times of tight labour markets.

Between 2006 and mid 2007, Irish minimum wage rose from €7.65 to €8.65 per hour, implying an associated decrease in employment of the younger workers of 1.3-2.6%, or up to 4,800 individuals amongst those under 25 years of age. Translated into the period of rising unemployment, the elevated rates of minimum wages in Ireland today are likely to be responsible for keeping up to 10,000 younger workers outside gainful employment.


In the end the problem with the minimum wage laws is that they always attempt to influence the supply and demand, just as any price fixing cartel would intend to do. The truth is, in such cases, invariably, the laws of supply and demand win – to the detriment of the most vulnerable and the youngest in our society. For their sake, it is time to rethink our minimum wage laws, before a new permanent class of young, unemployed and unemployable becomes a reality of Ireland’s post-crisis economy.


Box-out:

This week, Standard & Poor's has finally thrown in the towel and cut the ratings of the Irish banks’ bonds. While the news that our banking system stability overall is ranked alongside that of Slovakia and Korea galvanized business news desks attention, two interesting parts of the S&P analysis largely escaped the media. S&P explicitly provides the proof that the Banks Guarantee and Nama jointly underwrite a bailout of the Irish banks’ bondholders. Absent the two measures, AIB bonds would be rated BB/Negative/C+, while Bank of Ireland bonds would be at BB+/Negative/BB-. If not for taxpayers’ cash, bonds of our three largest banks sold to the public would require a health warning, stronger than the one posted on a packet of cigarettes. Only IL&P would stay above the waterline with BBB-/Negative/B absent state intervention. This, of course, would only be achievable assuming that the company’s life insurance business will continue to underwrite its banking branch – an idea that should be alien to anyone with an ounce of sense. In a separate comment, S&P also directly linked the poor prognosis for Irish banking sector to our sick economy. Of course this contrasts Government optimism around Nama. Remember – Nama promises to restore credit flows via ‘repairing’ banks balance sheets. S&P says that the balance sheets will remain sick after Nama as there is no real support for credit quality improvements coming from our weak economy. You decide whom you believe – Government’s contrived ‘supply will restore demand’ argument or S&P’s view that ‘weak demand will drag down supply’.

Economics 31/01/2010: S&P, Gold and forward view on risk

Couple articles worth reading:

1) China bubble - here. In my view - the analyst is spot on - there is a massive bubble in Chinese economy. So large, when it goes, the entire global growth will be derailed. We are, in effect, now treading to closely to the 1932-1934 period of the Great Depression, when the markets forgot fear for a sustained Bear rally before rediscovering that risk mispriced is a disaster waiting to happen.

2) Gold - here. Great chart on 89% loss line.
A very promising direction on gold, of course, which is in line with (1) above.

Prepare for some fun. Take a look at VIX:
All supports are out at this stage and risk appetite is falling since the beginning of the year. Bonds rallying, S&P is taking on water. The only way from here for the likes of Gold is up, for DJA and S&P - down. Back to that 89% rule line in (2) above.

Economics 31/01/2010: February look

This is an unedited version of my article in Business & Finance magazine for February, 2010.

Over the last few weeks, a host of data releases – both Irish and international – have provided an insight into our economy’s performance over 2009 relative to our major competitors. The news, while predominantly adverse, still show an occasional proverbial silver lining.

Let us start on a positive note first. Per US Federal Reserve data, the current crisis has been yielding improvements in our productivity over 2009. Table 1 highlights this development.
Spurred on by the cuts in private sectors employment and nominal wages, Irish productivity has posted a 1.9% increase in 2009, just as the rest of the developed world experienced either deteriorating or much lower labour productivity growth. Of course, in part, our labour productivity performance was driven by a precipitous collapse in hours worked. It was also helped by the growing GDP/GNP gap. This makes our productivity expansion over 2009 somewhat superficial and attributable to the tear away performance of a handful of MNCs, especially those in pharma and medical devices sectors, where exports rose 20% on 2008 figures.

This means that although unemployment rose dramatically, cuts in hours and numbers worked were probably too shallow relative to cuts in output value. There is still some remaining surplus capacity clogging up domestic sectors – a problem that can only be corrected either via a significant increase in domestic demand or via a new wave of layoffs. Lacking the former, the latter is now appearing to be the case, with several larger employers announcing new rounds of redundancies in mid January.

Returning back to aforementioned data, it is interesting to consider just how large was the transfer pricing effect from our MNCs to our labour productivity growth. As no detailed data on such operations is available for Ireland, we have to look elsewhere for evidence as to what has been going on over the course of 2009.

One study from Germany – published last month by the CESIfo institute – shows that across 27 European countries, on average, multinational firms operating in lower tax regimes have managed to incur labour costs that are some 56% lower than those incurred by their domestic counterparts. These significant tax savings were, of course, taken not in the form of lower wages paid to the employees, but in higher profit margins booked through lower tax countries. And this was the average for 27 countries, of which Ireland sports one of the lowest corporate tax rates.

Incidentally, transfer pricing also explains the surprising data on FDI inflows revealed in mid-January by the UNCTAD. According to UNCTAD, 2009 was a bumper crop year for inward FDI into Ireland, with gross inflow of USD14 billion – a reversal of fortunes on USD20 billion gross outflow in 2008. These figures prompted a slew of rosy reports in the media. Of course, our gross FDI inflows also reflect the extent of transfer pricing being carried out through Ireland.

In 2009, Ireland-based MNCs booked record profits through their local operations in order to reduce their tax exposure back in the home countries. The proof of this is in robust corporate tax returns booked by the Exchequer. Now, there is a new push for tax arbitrage, and this time around its coming through beefing up the investment side of the balancesheet – higher investment in Irish subsidiaries today mean higher returns on investment booked tomorrow. Not surprisingly, there is no evidence of the USD14 billion new ‘investment’ to be found neither in terms of new employment in the MNCs-supported sectors, nor in much more realistic IDA end-of-year results.

One added point to our labour productivity growth figures is that even with record layoffs in 2009 we were clearly staying below historic productivity growth trend. In 1987-1995 our annual labour productivity grew by 2.4%, rising to over 3.4% in 1995-2000, before slowing down to 2.3% on 2000-2008. But the reversal of the economy out of full employment during the recession should have boosted our productivity growth beyond the 2.4-2.5 levels. Once again, the 1.9% productivity expansion, as positive as it is, shows that some slack capacity remains.


Clearly, shedding personnel with below average performance and reducing hours worked to their more optimal levels (reflective of the long term changes in private and public demand) has improved our competitiveness over the last two years. This, ultimately, leads to better prospects for future growth, and, as Table 2 below shows, is reflected in terms of labour input cuts over 2009. For example, Spain, which enjoyed higher rates of labour utlisation growth in 1995-2008 bubble than Ireland, recorded weaker hours contraction and thus lower productivity expansion during the crisis.
The net result of this is that despite having recorded the most dramatic of all EU15 states’ contraction in output, Ireland has emerged from 2009 with unchanged average per capita income position when compared against the US, as table 3 below shows.
Overall, these figures show that during 2009, private sector in Ireland has led the painful, but necessary process of productivity improvements that ultimately can provide a sound basis for restoring our economy to a new growth path. This is the good news.

The bad news is that despite having suffered unprecedented, compared to our competitors worldwide, cuts in overall employment (in terms of both numbers employed and hours worked), Ireland still remains below its historic trend for labour productivity growth. Barring a remarkable (and at this stage highly unlikely) return of robust domestic consumption growth, this means that 2010 will require further rationalization of employment to inflict deeper cuts into remaining surplus capacity.

Box-out:

The latest newsflow on Bank of Ireland and AIB strongly suggests that the current market valuation of the two banks is out of line with their balance sheet realities. Given current trends, the two banks may require a post-Nama recapitalization to the tune of €9.7-10.5 billion in total under conservative assumptions. Most of this recapitalization will have to take form of equity, as internationally, banking sector is moving toward much higher proportion of equity in overall composition of Tier 1 capital. Given that this amounts to over three-and-a-half times the current market value of the two banks and over 6.5 percent of Irish GNP, a recapitalization at these levels will mean two things for the current shareholders. Firstly, share prices target following the rights issue will be around €0.65-0.75 for AIB and around €0.5-0.6 for BofI – multiples below their current trading ranges. Second, barring a miracle spike in demand for distressed assets by international investors, the new rights will have to be mopped up by the Irish Exchequer. Even assuming extremely generous (to the banks) pricing conditions under the preference shares purchases back in 2008, the new rights issues will imply possible state ownership of up to 80% of AIB and up to 75% of BofI. Current shareholders, thus, are facing a double squeeze on their shares values – one from the volume of new issuance, and another from a massive dilution of their rights (by a factor of 5 times the current warrants held by the State).

Interestingly, my estimate, based on the macroview of the banking system in Ireland as compared against the UK counterparts is basically in line with last month’s research note on the two banks by RBS which put post-rights price target of €0.70 for AIB and €0.52 for BofI, with the prospect of up to 75% state ownership of the banks.

Another interesting aspect of the RBS note is that it provides an estimate of €20bn of cumulative loan losses for the two banks; “majority of which will be crystalised over the next two years”. These losses are linked by the analysts, in part to the banks participation in NAMA, but also due to expected increases in funding costs and the real risk of political intervention. Of course, this column has warned about exactly these risks to the Irish banks valuations for over a year now.

Economics 30/01/2010: Eurocoin and Obama's new-old plans

Two topics worth covering: the Eurozone leading indicator issued last week and President Obama’s new ‘Tougher on taxes’ talk to the Congress…


First, the usual monthly update on Eurocoin – a comprehensive leading indicator for Euroarea growth. After straight 12 months of rising, the indicator is now standing at the level not seen since March 2007.
This is consistent with a strong growth signal for months ahead for the Euroarea core economies.


Now to the story of the week that was not covered (at least not from this angle) in our press. In his State of the Union speech this Wednesday, President Obama said,
“To encourage ... businesses to stay within our borders, it is time to finally slash the tax breaks for companies that ship our jobs overseas, and give those tax breaks to companies that create jobs right here in the United States of America...”

Oh, boy – this is turning into one of those typically European sagas: occasionally, the EU is prone to produce daft laws and proposals – the Insurance Gender Directive is a good example of one, the Lisbon Agenda is another. In a typical EU-fashion, bad ideas never die. They just get dragged into the closet, rested for a couple of years and then unleashed again. Until even the daftest policies pass into power.

Well, now it is starting to look like the Obama Administration is taking the same approach.

Under current law, income earned abroad is taxed according to two separate categories: general and passive. Passive income covers capital gains, dividends, and other returns on investment. What’s left is general income and it is subject to a higher rate of tax – the corporate tax.

Under the Obama proposal, a US corporation will have to compute its foreign tax credit on an aggregated basis – taking all foreign earnings and profits of all its foreign subsidiaries and subtracting total foreign taxes paid. If that isn’t bad enough, subsidiaries in higher tax countries will face a ceiling on how much credit they can claim against their earnings for the purpose of the Federal tax liability.

There is absolutely no reason for this, and in fact it is arguably a discriminatory policy, but hey – when it comes to ‘tax and spend’ madness, no one can beat the Democrats – the Feds are estimating the net revenue from the measure to reach between USD24.5bn (US Treasury estimate) and USD45.5bn (JC Committee on Taxation).

And all of these taxes will apply before the companies actually repatriate earnings back to the US.

Now, all of this has some connection to Ireland Inc. We’ve heard before some experts (usually from the companies that can’t really tell us what they think in fear of upsetting Government officials) saying that Obama Plan is not a biggy threat to Ireland. That, you see, our MNCs are here because our workforce is packed with Nobel Prize winners (we are that good at education!) and our energy/water/communications/transport/etc infrastructure is so world class. They are, the MNCs that is, here not because of tax arbitrage… But seriously – we do depend critically on US MNCs operations in the country.

Here is an interesting comment on the Obama speech from an Indian specialist site dealing with outsourcing:

“A tax expert from one of the top four auditing firms, who did not wish to be identified, said: "I think Obama is talking about the same thing when he took over as President. The way this works is; captive units of US firms in any other geography (it could be India, Philippines, China, etc.) are considered different entities under US tax rules. US firms pay tax on the income from these subsidiaries only when they repatriate these earnings (profits) to the US. Firms need to pay 34 to 35 per cent of federal tax on these earnings. In most cases, US firms do not send the money back to the US as they continued to invest this money in expansion and other operations. Now the US government is saying it will match deduction and income together, so they will not get the tax benefits," he said.

The thing is – India and China and many other locations will probably be ok, because they provide high productivity relative to low cost base. Ireland doesn’t do either. So what will keep the MNCs here if Obama gets his wish? For the next 5 years – the capital already sunk here. But after that? Not much. No, really, not much…

Economics 29/01/2010: News from the Knowledge Economy Front

Newsflash from Ireland's Knowledge Economy Front - our troops, led by heroic fighter for Knowledge, Batt O' "Modern Science" Keeffe, are now engaged in an orderly strategic retreat into the Darker Ages. Casualties are so far minimal - 228 scientific journals that Batt could not read.

As was reported by me earlier (here), Ireland's knowledge economics have suffered a fresh wound on our Government's hasty retreat from the world of the 21st century research back to the depth of the 19th century paper-based studies. Here's the latest dispatch:

"You will be aware that the current round of IReL funding came to an end in December 2009. The IUA Librarians' Group is engaged in positive discussions with the HEA and others to secure funding for IReL for 2010 onwards but it is likely that this will be at significantly reduced levels. Due to increasing publisher costs and other factors it is necessary for some IReL resources to be cancelled even if IReL funding were to be maintained at pre-2010 levels. Arising from this, and in the first of what will probably be a number of cancellation processes, the resources listed below will shortly become unavailable through IReL. To download the full list of journals and other resources, please click here."

I would encourage you going to the link and checking out the premier academic titles that will no longer be available on-time, on-demand via electronic libraries.

As one senior research academic commented on this: "What sort of insane gibbering passes for our education and research policy?"

As I was informed by the sources close to the DofEducation - as a compensation for unnecessarily complicated scientific titles lost, the Government will supply our Universities with the latest edition of Gaelic translation of the EU Treaties - after all, our Brussels-based Irish language translators are:

• costing us some 5 times the amount it would take to restore our library services back to the 21st century standard, and
• have no readers for their output anywhere on the planet Earth...