Economics 24/01/2010: Knowldge Economy and Irish academia

Charles Larkin and Brian Lucey are having a go at the issues clogging up Irish third level policies in Sunday Business Post today.

Here are few takes and my views on them:

“Hardly a week goes by without a government spokesperson discussing an aspect of the "Smart Economy". In the public and perhaps government mind this is equated with technology. We suggest that a truly "Smart Economy" is not based on technology -- the really smart economy is about flexibility, especially mental flexibility. Developing this should be the primary focus of the higher education sector. We suggest that there exist a set of interlinked issues that make the sector as it stands unable to do this.”

Yes – Knowledge Economy is not about quantity of labs / patents / ICT applications etc. It is about our abilities to create new applications and tools, but more importantly – ability to deploy these in profit earning undertakings (I mean, of course, a broader notion of profit that can, should the individual owners of technology and/or skills elect to do so, include pursuit of non-monetary returns).

“Irish higher education suffers from a severe conflict of mission. It is expected to deliver on innovation, education, social enrichment, economic growth, public health, improved lifestyles and put a chicken in every pot. Though research suggests that all of these and more arise from higher education, the effect varies across individuals and disciplines. The context is further complicated by the regional imperative.”

Also spot on – the conflict between objectives of the universities that are political (and this now also includes science policies) and that are academic is best highlighted by the fact that Irish universities are no longer the hot beds of subversive thoughts. Instead, they are staffed and run by bureaucrats with singular mode of thinking – coalescence, assimilation and homogenization of staff to achieve pleasant singularity of view that can then be monetized via Irish and European grants.

Not a single Irish university today would have seen Keynes offering a job to Hayek. Only senior faculty are allowed, and even then – unwillingly – to express dissenting views. Any junior faculty member peeping their head above the grey mass will be thrown out as soon as their contract comes for a renewal. ‘Does not match strategic direction’ on a rejection letter for a job means that the candidate is simply not ‘slottable’ into the Borg collective of some department.

Can anyone expect any sort of creative excellence out of this?

“Academic freedom is perhaps the simplest and yet most profound step. In essence this would involve the granting of "university" (i.e. degree granting) status to all third and fourth level institutions (inclusive of exceptional legal entities, for example the research-orientated facilities, such as the Royal Irish Academy and the Dublin Institute for Advanced Studies). The announcement by Minister O'Keeffe that he is to abolish the NUI is a first, faltering step towards this... Care needs to be taken that we do not replicate the failures of the UK and Australia in similar reforms. Within the IOT sector new programmes go through a very rigorous evaluation. The issue is that existing programmes need root and branch reform to ensure that they are at the same quality and intellectual standard. With freedom comes responsibility, and the most important responsibility will be to offer educational programmes aligned with the fostering of flexible minds.”

I fully agree – which probably means the authors are now at a risk of being branded ‘extreme’ in their views – freedom must be given to universities and all third level institutions, and they must be self-accountable for their actions. If one chooses to pursue EU and Irish academic handouts through so-called ‘collaborative’ piggy-back-riding on other EU researchers grants, so be it. They will sink in the long run, having reduced themselves to the backwater of unoriginality in thinking and output. If other universities chose to take a bolder position and once again become centres for debate, discussion, challenge and search (breaking away from their current tradition of serving as yes-men to the social regime of singular ideological hue) – they will thrive in the long term as their creativity will allow them to command a premium. The same premium the relative start ups of Stanford, UofChicago, University of California campuses, and so on – having arrived to the university game in the US well after the Ivy League institutions – now command over the majority of previously mighty, now completely mediocre Ivy League institutions.

Last night, RTE was showing the documentary about the Bog Bodies discoveries. In the entire lengthy feature, there was not a single point at which the documentary managed to show any disagreements between numerous Irish and international researchers. Instead, it was a saccharine, sonorous and harmonious blandness of: ‘Yes, I agree with my colleague on this point’ and ‘We all agree with our colleagues on all points’. I am certain that there were probably different views discussed by scientists amongst themselves. But the telling feature of the documentary was just how important consensus is to science’s image in the public. And this is frightening. Not a single major breakthrough discovery in science was delivered by consensual group-think of collaborative researchers.

Back to Brian and Charles’ essay:

“Freedom should be extended to faculty wages. At present, within narrow bands, the best are paid the same as the worst, the most active the same as the least. …Evidence from the US indicates that salary freedom can assist in incentivising staff, but this can arise at the cost of over-reliance on casual and adjunct lecturers at the undergraduate level. …we need to ensure that in the newly freed institutions a motto of "every scholar a teacher, every teacher a scholar" is taken just as seriously.”

I am not sure about the ‘over-reliance on casual and adjunct lecturers’. In my view, and a disclosure is due here – I am adjunct myself, adjunct lecturers are usually self-selected individuals with passion for teaching and with different sets of skills from other researchers and academics. If selected on merit, they can add serious diversity of thought and experiences to the universities. They are also key to linking universities to the real world. What is really sad about Irish universities is that casual lecturers are often selected for a single shot teaching, filling in for absent full time faculty. There is neither coherence, nor open-mindedness as to how adjuncts are selected, appointed and contractually hired.

“Freedom must also of course mean freedom to fail. If a university were unable to deliver on the required educational outcomes then it ultimately would be required to fold or to be subsumed by another more successful university and mechanisms need to be put in place to deal with the fall-out if this happens.”

This really needs no qualification. Superb! I lamented on many occasions the lack of consolidation and closure in the process by which universities that thrive can gain market shares.

“We suggested earlier that a truly smart economy involves the production of flexible thinkers. Such an education must be more than purely discipline-focused at the third level. …We can broadly consider three domains of intellectual activity in universities- humanities, letters and the social sciences (arts), life sciences and natural sciences. Mapping degrees to one of these we suggest that a true university education would involve an annual minimum of 15 per cent engagement with each domain.”

Very well put. Again, on many occasions I raised this concern that we are not producing flexible, creative thinkers, but are focused on producing standardized degree-holders. Like a commodity product, these degree holders are then released into the real world where they go on to form a mass of uncreative, unchallenged and unproductive middle managers and functionaries. The future of Ireland Inc rests with people who can deploy creative and innovative thinking in management (not necessarily in the labs alone, but at all stages of production, marketing, delivery, sales etc). This is what I would call a real ‘knowledge-based’ economy. It is good to see that at least two of my colleagues are now publicly in agreement.

“To adequately provide these postgraduate courses all academic staff in the university would be required to be active researchers, which would be achieved by a rolling tenure system. This would involve the granting of tenure for a prospective 5-7 year period, with biannual reviews.”

Spot on!

“Research activity and research quality are only loosely related but quality requires activity as a prerequisite. To ensure quality of teaching we suggest that again there be biannual reviews of teaching based on best modern practice. This would involve some element of student feedback but would also involve reflective portfolios and classroom observation. To oversee this quality issue we suggest a single evaluation unit within the above suggested ministry.”

Sadly, although I agree with the idea of a review, I am not yet ready to place my trust in Ministry bureaucrats to deliver on such an objective. Fas experience shows that our public officials cannot be entrusted to do this job in an impartial, efficient and effective manner. I would rather suggest use of class numbers, relative to faculty averages, as a partial metric for academic wages. Taken, of course, over a period of time and within comparable disciplines. Students tend to vote with their feet.

“A third element relates to funding. …Separating undergraduate from postgraduate education we suggest allows greater clarity to emerge. Persons seeking to take masters or doctoral qualifications in an area do so for one of two reasons -- a desire to seek entry to an area or profession (investment) or from a personal interest (consumption). There is no obvious reason why the government should fund the latter over other consumptions. In any case the operation of the tax/PRSI system should, in most circumstances, offer a return to society partly via the increased taxable earnings that the better qualified persons achieve, thus capturing the public good element of an increase in, for example, dentists, or telecommunication engineers, or doctors of literature.”

I actually disagree. PRSI and income tax place a surplus taxation burden on individual investment. If a person invests their own funds in education, they should be able to deduct the cost of this investment before they pay tax on capital gains. Secondly, if the society at large already benefits from the social good nature of higher education, then a person having invested in it for private benefit must be reimbursed for society benefit accruing not to themselves, but to others. After all, if my money paid for my PhD and I get a return of x% per annum, while the society gets y% per annum and a tax return on my PhD – is this not a case of double taxation?

This means that, while I fully agree that the state should not provide funding – except that based on merit and inability to pay considerations – for post-graduate studies, I disagree that PRSI/income tax should be viewed as fully functional means for capturing individual gains.

Economics 23/01/2010: Knowledge economy infrastructure

Some interesting data from a study "Broadband Infrastructure and Economic Growth" by Nina Czernich, Oliver Falck, Tobias Kretschmer and Ludger Woessmann, CESIfo Working Paper 2861 published in December last year that provides good comparatives for Ireland relative to the peers in terms of what I would call rudimentary 'Knowledge Economy' infrastructure -

• the relationship between physical capital and knowledge-related capital (broadband penetration and education); and
• the relationship between GDP per capita and the above

all taken over a long period of time (1996-2008).

First, broadly, the findings of the study itself: "We estimate the effect of broadband infrastructure, which enables high-speed internet, on economic growth in the panel of OECD countries in 1996-2007. Our instrumental-variable model ... [shows] voice-telephony and cable-TV networks predict maximum broadband penetration. We find that a 10 percentage-point increase in broadband penetration raises annual per-capita growth by 0.9-1.5 percentage points. ...We verify that our instruments predict broadband penetration but not diffusion of contemporaneous technologies like mobile telephony and computers."

Interesting - a 10% increase in broadband penetration ups the growth rate by 0.9-1.5%. In other words, to get a 10% increase in GDP per capita out of a 10% rise in broadband penetration requires 6.4-10.7 years. Not a bad return. The problem here is that, of course, the starting levels from which this effect is measured are low, so the law of diminishing marginal returns has to kick in somewhere.

I took their data and run through some of it in a very crude way to see if I can glimpse other interesting aspects. Here are the results.
Maximal (for the period GDP per capita, PPP-adjusted) with 2 standard-deviation 'candles' around it. Notice two broadly defined groups of countries: Overperformers (including Ireland) and Underperformers. Now, I know - I shouldn't be using GDP here, but I am not about to make a statement about the actual 'wealth' or 'riches' of Ireland, so GDP will do.

Next, take a look at scatter plot relating GDP per capita to two measures of communications sector performance: broadband penetration for 2008 (the end score, if you want) and starting point measure (voice telephony penetration back in 1996).
It looks like GDP per capita in the end is much more responsive to increases in broadband penetration than to the starting position. In other words, economies with low legacy stock of communications seem to be catching up through broadband penetration improvements. Is this suggesting that a country can leapfrog weak communications sector legacy by jumping straight into broadband age? Well, sort of. The problem here is that we do not separate out the twin effects of growth in broadband penetration (much higher for countries doing leapfrogging) and simultaneous growth in voice telephony penetration (also likely to be much higher for countries doing leapfrogging).

A very revealing chart next:
Let us take physical capital as a share of GDP and compare its effects on overall GDP per capita, against the same effect being induced by education. What is unambiguous is that countries with higher physical capital base share of GDP tend to have lower GDP per capita. How come? Because they are physical capital-intensive, i.e their production is stuck in the late industrial age. Countries with higher education are more labour-intensive and especially skilled-labour intensive, and thus have higher GDP per capita.

Note Ireland. It is relatively poor in physical capital per GDP and yet relatively rich in GDP per capita. Why? Because we do have a modern economy - an economy where value is added through human capital side (of course this happens much more on the side of MNCs, where transfer pricing is used to import, artificially, human capital-intensive value-added, but it also happens in services economy, in our IFSC, etc). And yet, our education measure is far from being impressive.

The gap between our unimpressive levels of education and the levels of education consistent with the 'average' OECD pattern of relationship between education and GDP per capita, to me, clearly shows the importance of transfer pricing in our GDP figures. This gap is captured here by, in effect, showing that our capital and human capital stocks cannot support our GDP fully!

Here is more detailed view of our physical capital stock relative to our education (human capital stock).
Ouch. We are an outlier precisely in the direction suggested by the gap identified above. Note that moving to a 'Sweet Spot' of highly productive economies with significant rates of utilization of human capital requires both - more physical capital formation and even more education. Also note just how inefficient is the stock of education in the upper 'bubble' group of countries that includes all Nordics, Japan and France. These countries are simply not being able to derive the same returns to education in terms of GDP per capita as the 'Sweet Spot' nations.

So here is a question no one is asking - is there such a thing too much of education? Is there an inverted U-curve for the relationship between education and income, whereby too smart for its onw good society leads to suboptimal levels of growth? After all, since the 1990s we are seeing an emerging trend in the developed world whereby the new generations of slackers are increasingly composed of highly educated people...

This is not an argument out of the blue - take example of a potentially 'too livable city' concepts discussed in a brilliant article here. Can the same happen to the 'too-knowledgeable-economy'?

Ok, couple more charts on the same point. Broadband penetration is positively correlated with capital formation... Hmmm. This might reflect the fact that higher stock of capital imply better infrastructure through which broadband can be delivered. The relationship is not very strong, though.

And there is an even weaker, and negative, relationship between education and physical capital. This negative coefficient of correlation does suggest, though, that we are in the early stages of the process whereby physical capital takes second seat to human capital in characterising modern economy. If so - good news for 'Knowledge' economists out there - machines do not possess knowledge. People do. But it is also bad news to all social engineers out there who still think technocratic management of economy/society is possible. Knowledge requires heterogeneity and creativity. And these are antitheses of planning and policy-driven controls and incentives.

Far from being dead, the age of Friedmans' Freedom to Choose is only dawning!

And the final point: education and broadband infrastructure are much more strongly (almost 4:1) positively correlated with each other than they are with physical capital.
This, of course, can be interpreted as a warning to the folks interested in restricting the freedom of people to communicate. If China, and other countries that impose controls on internet, want to have a 'Knowledge'-intensive, modern economy, they will have to deliver real (i.e. free of political ideologies and biases) education and meaningful (i.e. free of political 'bottlenecks') knowledge infrastructure (in this case, broadband).

If they don't, the risk is they will end up being physical capital giants - countries where the world does its 'dirty work' of mass manufacturing widgets...

Economics 20/01/2010: Knowledge Economy and Dublin Water woes

It is beyond any doubt that Ireland has had its share of bizarre unlucky events and disasters:

1. Man-made crises: economic recession, banking collapse, fiscal meltdown, construction/property bust and policy/regulatory legitimacy, a schism between the public sector and the ordinary folks trying to make a living (yes, it is back - industrial strife is now clogging our transport and threatening our healthcare system);
   
2. Natural: swine flu, measles pandemic (remember that one?), floods, a snow storm, a freeze, most current - vomiting bug is apparently back;
3. Natural/man-made: water shortages (with parts of the country still covered in floods).

There have been severe costs imposed on people and the economy at large. And there are lessons to be learned and, hopefully this time around - few people responsible for (1) and (3) to be punished.

But one lesson has not been discussed to date. Recall a year ago, the Government came out with a grand plan for creating a 'knowledge' economy in Ireland. This plan is still alive (as plans go), although, of course, nothing has been done to deliver on its promises. Now, the EU is about to come out in February with a comprehensive platform for building a brighter better Union through 2020. I've seen the document. It too aims for 'Knowledge Economy' thingy.

So now to the lesson of our crises: 'Knowledge Economy' needs functional, efficient and excellent services. Public and private. Functional, efficient and excellent services is what our public sector simply cannot deliver.

That was, of course a two part proposition.

Let us take the first part: 'Knowledge Economy requires functional, efficient and excellent services". I hope this is pretty much apparent:

• PhDs and high quality entrepreneurs who will fuel the 'Knowledge Economy' will require good housing (as opposed to substandard shoe-box apartments we built for cheaper laborers during the Celtic Tiger boom), good on-time and on-schedule transport systems (as opposed to completely random travel times at Dublin Bus), cheap and quality air connections to the rest of the world (as opposed to what passes for airport out on the North side of the city), high quality healthcare (as opposed to waiting lists for tests and procedures measurable in light years instead of days), affordable and superior in quality education for their children (as opposed to schools where teachers do not engage in any post-university life-long training and where doors are shut after 3 pm - when the rest of us, mortals - have to be at work) and so on. They will require parks that are safe and pleasant, the sea front that is free of industrial rubble and incinerators. And air that is clean.
  
• PhDs and high quality entrepreneurs who will find these services wanting in Ireland will require either a much higher rate of pay, making their output, no matter how much 'Knowledge'-infused it might be, uncompetitive in the world markets. Alternatively, they will simply move on to build 'Knowledge Economy' somewhere else - in Paris or Singapore or Hong Kong, where such services (also known as inputs into the 'quality of life') are better and more efficiently supplied.

Agree? Ok, second part of proposition needs to be proven. Does it? Really? Anyone still believes that our public sector delivers excellent services? Or that the shambolic quality of these services has nothing to do with knowledge economics?

Instead of proof - an example. We all can agree that our nation's top university is and must be at the centre of the 'Knowledge Economy' activity. It must be its heart. Well, the speed of the body is related directly to the speed of the heart beating. Here is a snapshot:

From today's email to faculty and students (this is a second such notice this week):

"Dear all,

As we are all aware following the severe cold weather...

Within College we use a large amount of water and must during this period make an additional effort to reduce our water consumption. ...The following water saving tips should be considered by all [I omit the measures proposed that actually should be a normal practice for all times, not just at the time emergency]:

· In laboratories reduce water consumption for vacuum pumps and water cooled condensers

· Ensure all water supplies are turned off when experimental work is complete

· Only run dish washer, glass washers and autoclaves when full

· Consider can any experimental work consuming water be stopped during the current water crisis"

Of course, conserving water is a good practice - it is a scarce resource and should not be wasted. But if three days of snow and -3 degrees temperature can stop experimental work and lead to reduced operational capacity of our best University, are we really getting the public services that can support 'Knowledge Economy'?

I personally don't think so. So why on earth have our policymakers - wise enough to set numeric targets for PhDs well into the first half of the century and capable of producing tomes after tomes of white papers on 'Knowledge' economics - have so utterly failed to even mention the need for proper electricity supply (yes, TCD routinely warns staff that the University is teetering on the top edge of its supply capacity and that ESB supply might be disrupted) and decent water supply?

Before science and technology policy proposals, shouldn't we be first served with a decent emergency response system that can make sure flooding is contained when it happens, roads are gritted when the icy conditions advance and water/power/communications/gas/energy are delivered when adverse weather hits? It might be not 'Knowledge'-intensive and not too glamorous of a task, but it would serve a much greater purpose.

Economics 20/01/2010: Banking Inquiry

I have three simple points to contribute to all the discussion concerning the Banking Inquiry proposals:

1. Any Inquiry must be fully public, to the point of live television broadcast of all proceedings. Imagine a case of not one, not two, but six largest hospitals in the nation recording serial acts of systemic malpractice that were to result in some Euro 70 billion worth of damages. Would Mr Cowen call for a closed-doors inquiry?
2. Any Inquiry must be swift and must lead to convictions and severe punishment of anyone found guilty of malpractice or non-fulfillment of duties (including public officials in charge of regulatory and supervisory functions, should they be found guilty). Imagine a total collapse of six largest bridges in the country at the peak traffic - would Mr Cowen sum up the situation as 'We are where we are, now is not the time to deal with the past'?
3. Any Inquiry that does not cover Nama and Banks Guarantee scheme will simply fail to deliver full account of the causes and the full extent of the damages caused by the current crisis. This is why I oppose an idea of the 'wise men'-drafted preliminary report to set terms of reference for the second stage inquiry. Given this Cabinet will be selecting the 'wise men', I have serious doubts as to the integrity of the process or the group put in charge of restricting any direction of the future inquiry.

Ireland needs its own Truth & Reconciliation Commission to deal with the systemic failures of our supervisory, regulatory and banking systems. If public operation of such a Commission results in irreparable damage inflicted on our banks - how can one tell? After all, with Anglo at the helm, these banks have already done enough to damage themselves. The price of keeping them alive on artificial respirator of paucity, opacity and public cash is the collapse of public trust in our institutions and in our financial system - a price that is much higher than the withdrawal of all international bond holders from Ireland Inc can ever be.

After all, am I the only person one noticing the complete and total ethical collapse of our social system that takes ordinary folks' money to pay the cost of the full and unlimited guarantee of the (largely) foreign bondholders in Irish banks, while their own deposits are now under the risk of being covered by a limited guarantee up to Euro100K?

Economics 20/01/2010: Long term comparatives for Ireland

Some time ago I promised to publish some long term macroeconomic comparatives for Ireland relative to other small open economies of Europe. Here they are (all data is courtesy of the IMF's Global Economic Outlook dataset with some forecasts adjusted to reflect Government own forecasts in Budget 2010):

First output gap as percent of potential GDP

There is really no doubting who's worse off in this picture. And notice how much more dramatic is our output gap volatility compared to, say, Austria - another small, but more stable economy, despite it having a massive exposure to high growth and high volatility Eastern and Central European countries.

Next, we have GDP per capita.

Several features of the chart are worth highlighting.

Obviously, Iceland is now on the path, per IMF to close the gap between themselves and us in terms of GDP per capita. Dynamics-wise, it is expected to do better relative to Ireland than it ever did in the period since the late 1990s through the bubble. Taking medicine on time and in full, obviously pays for Iceland. Back in 1999 Ireland moved onto a path of GDP per capita in excess of Iceland. In 2009 it moved on the path of GDP per capita converging with Iceland.

Who's doing better here? By the end of 2014, Iceland is expected by the IMF to fully recover from the crisis, reaching peak GDP per capita once again, after a shorter recession than the one enjoyed by Ireland. And Iceland will do so with faster growth in population than Ireland will (see later charts).

Under DofF dreamy assumptions, Ireland too will reach its pre-crisis peak by 2014, but it would have taken us a year longer to get there than Iceland. And this is under DofF assumptions.

Now, I also provide my own forecast - somewhat gloomier than that of the Government - which implies that i do not expect Ireland to reach the pre-crisis peak income per capita any time soon. And this dynamic will be paralleled by a slower growing population.

Also, do remember - our GDP is not a measure of our income (GNP is), while for Icelanders the two measures are more closely related.

Next inflation as measured by CPI:
Do tell me we are just fine with 5% deflation in the current cycle. Not really, folks. In order to get us back to price levels that imply competitiveness, we need a good 40% deflation if not more.

Unemployment - the one that we are being told is getting better now that 'the worst is already behind us' per official Government view:
Again, think Iceland and Greece. Greece is a good one in particular - their unemployment was high since the late 1980s. Ours was low since the mid 1990s and sub-zero since 2001. But, thanks to our 'head-in-the-sand' economic policies during the current crisis - we are now at the top of the league.

Demographics - some say this is our saving grace, the golden 'get-out-of-the-slump' card:
Nothing spectacular that I can spot here. And these are IMF projections that lag in incorporating what we, on the ground already know - the rapid depletion of our foreign workers' population and waves of young Irish people leaving the country.

Let's take a look at employment (as opposed to unemployment) as % of the total population. basically, the higher the number, the lower is the country dependency ratio (in other words, the greater is the number of people working than the number of people they support):
We were doing pretty well - just below Iceland and Switzerland. Post crisis, Iceland will retain its second best position, but we will slide below Lux. Again, this is in the environment where our population will be growing slower than that of Lux...

General Government Balance:
Well, yes - per Brian Lenihan we have taken the necessary steps... Did we? How is fooling who here? Iceland will be ahead of us with default and without a mountain of international bondholders' and depositors' liabilities on the shoulders of its people. We will both, destroy our public finances and our private households' finances as well. All for what? To make sure we do not upset banks bond holders? But wait - these figures do not reflect Nama and its cost. They do not reflect future bank recapitalisations. Were they to do so, our Government Balance would have fallen way beyond 16-18% mark.

But let us take a different look at the same figure:
Now, remember all the talk about Charlie McCreevy being a profligate spender as the Minister for Finance. Actually, not really. Over his tenure - longer than that of his successor, McCreevy presided over relatively mild deterioration in fiscal position. Primary balance under McCreevy in cumulative terms was close to break even. Under Minister Cowen things spun out of hand. Noticeably, Minister Lenihan is doing a much better job than his predecessor, although it is hard to say whether he is doing it because he actually believes in some sort of fiscal discipline or because he simply cannot borrow all the money he would like to borrow.

Current account balance:
For an economy that is staking its survival on exports (and we really do not have much of hope of doing otherwise), we are not looking all too strong in 2010-2014 projections by the IMF. Iceland, in contrast, is looking mighty alright relative to us, having undergone massive devaluation. Again, our deflation at home is simply not enough to compensate for the fact that we cannot devalue the grossly expensive euro.

Let me take you through more comparatives. Back to Government deficits. Now, recall there are two components to deficit - structural (due to chronic overspend) and cyclical (due to a recession).
Again, notice how Greece and Austria are on virtually identical path, although Greece is above Austria. This means that on average, the share of their overall deficit that is structural is relatively the same. If Greeks were to cut their structural deficit relative to its position today, their overall deficit will decline by a lower percentage than the same drop for Ireland. In Ireland's case, we have smaller cyclical deficit than the Greeks do, but greater structural deficits. Relative to Austrians, we are simply a drunken sailor hitting the first pub on the shore.

Take a closer look at the Irish data alone:
In the 1980s through late 1990s - much lower structural deficits than since 1998. Why? I guess Bertie really was a profligately spending socialist of the old variety.

Last chart: just to drive home the same point as before: Note the dramatic deterioration in structural balances under Mr Cowen - throughout his years as Minister for Finance, he was spending not only the money he had (shallower surpluses than his predecessor), but also the money he did not have (deeper structural deficits), leveraging lavishly future generations' wealth. Mr McCreevy, in contrast, really was spending what he had, with structural deficits starting to cause problems in his tenure only around 2002.
And one last point to make - notice how our structural deficit has caught up with its 5-year moving average line. This suggests that even in the Budget 2010 we still did not do enough to reverse longer term trend leading us deeper and deeper into permanent insolvency.

Paraphrasing Fianna Fáil's 2002 general election slogan: "A Little Done, More To Do"...

Economics 19/01/2010: Irish banks - a rational model of risky strategies

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. 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 (beefing up collateral) 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.”

Economics 19/01/2010: Nama - adverse selection is happening

Newspapers today are reporting that banks may be pressuring Irish developers to sell their UK assets to write down the loans that are bound for NAMA. This is an interesting development. As UK market has shown some signs of revival (although these signs are tenuous at best), prime properties with less recent vintage can be sold off to generate cash to pay down some loans. Now, the problem for Nama is that of selection bias.

On one side of this equation, developers willing to do this will be disposing of the more liquid and better properties, depleting their own risk-weighted assets base.

They will be using cash to pay down the loans that are marginally at the boundary of being transferred to Nama. Why? Elementary, Watson!

Suppose Nama imposes a discount of 30% on your loans. You have two loans. One is recoverable at 80%, another at 0%. You have a choice – pay down one loan and let the other go Nama. If you take loan A with 80% recovery, you get 70cents on the euro from Nama. If you hold it to maturity you get 80 cents. If you take loan B with 0% recovery, you get 70 cents on the loan from Nama and zilch from the market. Guess which loan will be repaid and which will be heading for Nama?

In the mean time, naïve and inexperienced in collection and recovery business Nama is still sticking to 30% average discount claims, thus further incentivising this adverse selection process against itself. NAMA chief executive Brendan McDonagh few days ago repeated this much.

So the end game here is that, if the banks are successful, even poorer quality loans will be transferred to Nama, while Nama’s CEO is running around town committing himself to valuations before any valuations are even done.

Lovely.

Economics 18/01/2010: Systemic Risk Regulation EU-style

Before we dive into the issue of Systemic Risk Regulation, a quick note on travel industry troubles (those who would like to do so can skip down to the second topic)

Some of the readers of this blog and of my articles in press disagree with my assertion that high charges at the Dublin Airport and the travel tax imposed on passengers matter to our travel figures. I have wrote before about:

• an independent Government group report calling for abolition of the tax, and 
• on an independent economic assessment from international transport economics consultancy linking travel tax to jobs losses and revenue collapse in the sector; and
• evidence on routes closures and aircraft cut backs that were explicitly linked by the airlines (Ryanair, EasyJet and Aer Lingus amongst them) to the charges and taxes collected in Dublin. 
• Withdrawal of BMI earlier this year from Dublin, with a loss of 30 jobs and some 300,000 passengers was also not enough.
  

This was not enough to convince some. Sadly, many continue to insist that protectionist barriers to travel (trade) are an effective means for ensuring viability of Irish tourism and domestic sectors (see last Sunday Times letters page).

Now, Irish media reports that the DAA will be offering substantial discounts to airlines that launch new short and long haul services, amounting to 25-100% cuts in charges for the first five years of a route opening.

Of course, DAA had seen a 17% year-on-year drop in traffic in December 2009, while Cork saw a decline of 15.5% and Shannon – 29.9%.

Offering deep discounts is a funny thing to do, if the charges and taxes were not the problem with traffic in the first place. Unless, that is, people like myself have been all along correct in stating that high costs of services provided by the DAA (inclusive of travel tax – which DAA had nothing to do with) act as an impediment to sustaining tourism and business travel to Ireland.

It is a basic feature of international trade theory and practice – tariff protection does not work. Not in the short run, nor in the long run. Visitors to Ireland are price-elastic, while many of us, living here with families and connections (personal and business ones) overseas are less so.

Hike tax and foreign tourists will have a greater ability to avoid coming here, while domestic travellers will have to adjust their expenditure (abroad and at home) to cover the additional cost.

What the former means is that a Spanish person deciding on where to take a city break will be less inclined to chose Dublin or Ireland in general because of a higher tax/cost.

The latter means that an Irish person going to, say, Paris, will have an added incentive to shop there more (to generate greater savings over the comparable purchases in Ireland and thus compensate herself for extra costs incurred in travelling) or equivalently – to shop less in Ireland (to avoid incurring added cost). Both effects act in the direction of reducing total revenue to businesses based here.

Ann Siebert has weighed in on the issue of systemic risk regulation in Europe in today’s voxeu column (here):

"Any committee dealing with assessment of systemic risks “should be small and diverse. …ideally it should be composed of five people: a macroeconomist, a microeconomist, a financial engineer, a research accountant, and a practitioner. …As the size of a group increases so does the pool of human resources, but motivational losses, coordination problems, and the potential for embarrassment become more important. The optimal size for a group that must solve problems or make judgements is an empirical issue, but it may not be much greater than five. The reason for diversity is that spotting systemic risk requires different types of expertise. A board composed of entirely of macroeconomists might, for example, see the potential for risk pooling in securitisation, whereas a microeconomist would see the reduced incentive to monitor loans.”

Needless to say, these are not the principles taken on board by Nama and the Irish banks. Nor is it an approach even being discussed for the Irish Financial Regulator or the Government. Why? Why not?

“The committee should be composed of researchers outside of government bodies and international organisations; career concerns may stifle the incentive of a bureaucrat to express certain original ideas. It is of particular importance that the board not include supervisors and regulators. [Again, look at Nama – virtually the entire top management of this organization is composed of  people unqualified to deal with the task of spotting structural risks]. This is for two reasons. First, it is often suggested that supervisors and regulators can be captured by the industry that they are supposed to mind, and this may make them less than objective and prone to the same errors. Second, a prominent cause of the recent crisis was supervisory and regulatory failures, and these are more apt to be spotted and reported by independent observers than the perpetrators.” [No illusions here - Nama is captured by the industry, and to boot - by the worst parts of the industry, not the best.]

"Finally, it is important that the board be made sufficiently visible and prominent that a member’s career depends on his performance. Given the importance of the task, pay should be high to attract the best qualified, and the members should not have outside employment to distract them.” [Good luck to anyone who thinks that Nama board or any of its risk structures will come close to these parameters, except one - they will be handsomely remunerated for their work].

Alas, this dreamy transparent and professionally sound proposal is too late, even in the EU case, for: “The Eurozone has already swung into action, creating the European Systemic Risk Board (ESRB), set to begin this year. Unfortunately, this board, responsible for macro-prudential oversight of the EU financial system and for issuing risk warnings and recommendations, is far from the ideal. It is to be composed of the 27 EU national central bank governors, the ECB President and Vice-President, a Commission member and the three chairs of the new European Supervisory Authorities. In addition, a representative from the national supervisory authority of each EU country and the President of the Economic and Financial Committee may attend meetings of the ESRB, but may not vote. This lumbering army of 61 central bankers and related bureaucrats is a body clearly designed for maximum inefficiency; it is too big, it is too homogeneous, it lacks independence, and its members are already sufficiently employed.”

Pretty much on the ball, I would say.

Economcis 18/01/2010: Sunday Times 17/01/2010

Another recent article in the Sunday Times:

December Live Register figures show that this column’s earlier prediction of further deterioration in the employment and labour force conditions in Ireland for Q4 2009 – Q1 2010 are, unfortunately, coming true.

The Live Register now stands at 426,700 or 1,200 above the previous record set in September. Unemployment is estimated at 12.5 percent, and rising. Declining labour force participation and net emigration are now the only two factors that keep the unemployment rate from touching 14 percent today.

But the latest data shows that the situation on the jobs front is still worsening. Between December and November, Ireland’s ranks of unemployed swelled by 4,200, more than cancelling out the reduction in numbers achieved in October. Since March 2007 Live Register counts have fallen only once, despite the fact that we are now drawing record numbers of young would-be-workers back into colleges and training programmes.

The trend suggests that by the end of this year, we are likely to reach 13.5 percent official unemployment or higher. While the ESRI and many independent economists have highlighted the possibility that elevated levels of joblessness will persist for some time, few are willing to face the reality that the current trends and previous crises experiences across Europe, suggest that Irish long-term unemployment can remain at more than five times the rate prevailing during the Celtic Tiger era through 2020.

Broad as they are, the Live Register figures hide a much more unpleasant arithmetic that relates to the issues of growing long term unemployment, declining labour force, and the inadequacy of our policy responses to the crisis.

December Live Register shows that the majority of the seasonally adjusted increases in unemployment occurred in over 25 years of age group of workers – suggesting that the jobs losses are continuing to accumulate in core employment sectors.

More detailed QNHS results for Q3 2009 show that industry and manufacturing are now leading other sectors in terms of jobs losses. This week’s data for Q4 2009 industrial production confirms the bleak prognosis for jobs in these sectors. Computer, electronic and optical products and the overall modern manufacturing sectors are now deteriorating at the rates where employment levels in these high value-added activities are likely to come under threat in months ahead.

With more skilled and better educated workers joining the dole queues, the prospects of finding future employment for the previous Live Register signees are getting worse by the week. Many of these workers are now on the Register for 10 months or longer. In fact, from the beginning of the crisis through March 2009, some 196,000 people signed up for unemployment. Majority of these people have by now exhausted their redundancy payments and are facing transition to social welfare. They are Ireland’s new army of the long-term unemployed.

Long-term or structural unemployment is much more severe than that driven by a recession. Long term joblessness almost invariably leads to a loss of skills and lower marketability. It also results in a significant decline in incentives to seek employment or invest in future skills. Even in publicly-financed training programmes, internationally, the length of unemployment spell is negatively related to the training programmes outcomes.

Just how sticky the problem of long term unemployment is can be illustrated by the fact that during the Celtic Tiger era, as hundreds of thousands of foreign workers moved to Ireland, our long term unemployment remained static.

And Ireland is not unique in this experience. In the US, long term unemployment remained unchanged from the 1980s through mid-1990 s until the Clinton Administration reforms of the social welfare system. Across the Euro area, during the growth years of the last decade, significant declines in short term unemployment were accompanied by high long term joblessness.

Per latest data, in a year to October 1, 2009 for every five persons joining the Live two have moved into long-term unemployment, while more than one dropped out of the labour force. Thus, since the start of the crisis in Q4 2007, more than 140,000 people have either joined the ranks of the structurally unemployed or stopped searching for a job.

For these workers, there are virtually no existent policy platforms addressing the issues of skills and job search incentives.

Only holistic reform of the social welfare (aimed at reducing incentives to stay outside the workforce), a substantial cut in the minimum wage, plus a robust businesses-led jobs creation can return this pool of potential talent back to productive economy. A cut in an excise duty on booze, a car scrappage scheme and a microscopic drop in Vat comprising Government’s latest package of fiscal supports for a recovery simply won’t do.

Instead of businesses-oriented programmes aimed at stimulating exporting and domestic investment, our jobs creation policies are now shifting jobless off the official register into the twilight zone of hidden unemployment. CSO data quantifies two programmes, set up in 2009, through which taxpayers pay the unemployed to undertake Fas-supervised ‘jobs’. These individuals are not included on official unemployment roster. The Short-Term Enterprise Allowance (STEA) scheme pays workers to engage in self-employment. The Work Placement Programme engages welfare recipients in unspecified subsidized ‘employment’. In total, 3,785 individuals were ‘employed’ under both programmes at the end of September 2009.

One must question the ability of these workers to sustain employment without state subsidies at any time in the foreseeable future.

Absolutely nothing is known about the longer-term success of Fas-assisted programmes in general. Meanwhile, in countries where ‘involuntary entrepreneurship’ activities, such as STEA, are widespread, these programmes are often blamed for driving workers to accept sub-optimal jobs path in exchange for immediate income. In other words, involuntary entrepreneurship prevents many workers from actively seeking better jobs and/or investing in new skills.

A key to success of the work placement programmes rests with three broader principles, none of which appear to have been addressed by the policies put in place since the inception of the crisis.

First, selection mechanisms that determine who gets to participate in the programme must ensure that both the workers and the self employed are fully equipped for the challenges of the programmes. In the case of Fas-supported social welfare recipients programmes, the issue is whether the programmes actually select the best suited recipients with prior experience in the workforce.

Second, choice of businesses attracted into such programmes must be based on their ability to provide broadly marketable skills. Often, placement programmes box participants into jobs with firm-specific skills. Such programmes are only successful if they involve large and well-anchored employers. Even then, a restructuring or scaling down of Irish operations can leave these programmes participants with no transferable skills.

Third, the incentives to retain these participants in the labour force after the funding runs out must be put in place before the programmes commence. Clearly, absent a comprehensive reform of our social welfare system and minimum wage laws, this critical aspect of the programmes has not been followed through.

December Live Register figures show that this column’s earlier prediction of further deterioration in the employment and labour force conditions in Ireland for Q4 2009 – Q1 2010 are, unfortunately, coming true.

The Live Register now stands at 426,700 or 1,200 above the previous record set in September. Unemployment is estimated at 12.5 percent, and rising. Declining labour force participation and net emigration are now the only two factors that keep the unemployment rate from touching 14 percent today.

But the latest data shows that the situation on the jobs front is still worsening. Between December and November, Ireland’s ranks of unemployed swelled by 4,200, more than cancelling out the reduction in numbers achieved in October. Since March 2007 Live Register counts have fallen only once, despite the fact that we are now drawing record numbers of young would-be-workers back into colleges and training programmes.

The trend suggests that by the end of this year, we are likely to reach 13.5 percent official unemployment or higher. While the ESRI and many independent economists have highlighted the possibility that elevated levels of joblessness will persist for some time, few are willing to face the reality that the current trends and previous crises experiences across Europe, suggest that Irish long-term unemployment can remain at more than five times the rate prevailing during the Celtic Tiger era through 2020.

Broad as they are, the Live Register figures hide a much more unpleasant arithmetic that relates to the issues of growing long term unemployment, declining labour force, and the inadequacy of our policy responses to the crisis.

December Live Register shows that the majority of the seasonally adjusted increases in unemployment occurred in over 25 years of age group of workers – suggesting that the jobs losses are continuing to accumulate in core employment sectors.

More detailed QNHS results for Q3 2009 show that industry and manufacturing are now leading other sectors in terms of jobs losses. This week’s data for Q4 2009 industrial production confirms the bleak prognosis for jobs in these sectors. Computer, electronic and optical products and the overall modern manufacturing sectors are now deteriorating at the rates where employment levels in these high value-added activities are likely to come under threat in months ahead.

With more skilled and better educated workers joining the dole queues, the prospects of finding future employment for the previous Live Register signees are getting worse by the week. Many of these workers are now on the Register for 10 months or longer. In fact, from the beginning of the crisis through March 2009, some 196,000 people signed up for unemployment. Majority of these people have by now exhausted their redundancy payments and are facing transition to social welfare. They are Ireland’s new army of the long-term unemployed.

Long-term or structural unemployment is much more severe than that driven by a recession. Long term joblessness almost invariably leads to a loss of skills and lower marketability. It also results in a significant decline in incentives to seek employment or invest in future skills. Even in publicly-financed training programmes, internationally, the length of unemployment spell is negatively related to the training programmes outcomes.

Just how sticky the problem of long term unemployment is can be illustrated by the fact that during the Celtic Tiger era, as hundreds of thousands of foreign workers moved to Ireland, our long term unemployment remained static.

And Ireland is not unique in this experience. In the US, long term unemployment remained unchanged from the 1980s through mid-1990 s until the Clinton Administration reforms of the social welfare system. Across the Euro area, during the growth years of the last decade, significant declines in short term unemployment were accompanied by high long term joblessness.

Per latest data, in a year to October 1, 2009 for every five persons joining the Live two have moved into long-term unemployment, while more than one dropped out of the labour force. Thus, since the start of the crisis in Q4 2007, more than 140,000 people have either joined the ranks of the structurally unemployed or stopped searching for a job.

For these workers, there are virtually no existent policy platforms addressing the issues of skills and job search incentives.

Only holistic reform of the social welfare (aimed at reducing incentives to stay outside the workforce), a substantial cut in the minimum wage, plus a robust businesses-led jobs creation can return this pool of potential talent back to productive economy. A cut in an excise duty on booze, a car scrappage scheme and a microscopic drop in Vat comprising Government’s latest package of fiscal supports for a recovery simply won’t do.

Instead of businesses-oriented programmes aimed at stimulating exporting and domestic investment, our jobs creation policies are now shifting jobless off the official register into the twilight zone of hidden unemployment. CSO data quantifies two programmes, set up in 2009, through which taxpayers pay the unemployed to undertake Fas-supervised ‘jobs’. These individuals are not included on official unemployment roster. The Short-Term Enterprise Allowance (STEA) scheme pays workers to engage in self-employment. The Work Placement Programme engages welfare recipients in unspecified subsidized ‘employment’. In total, 3,785 individuals were ‘employed’ under both programmes at the end of September 2009.

One must question the ability of these workers to sustain employment without state subsidies at any time in the foreseeable future.

Absolutely nothing is known about the longer-term success of Fas-assisted programmes in general. Meanwhile, in countries where ‘involuntary entrepreneurship’ activities, such as STEA, are widespread, these programmes are often blamed for driving workers to accept sub-optimal jobs path in exchange for immediate income. In other words, involuntary entrepreneurship prevents many workers from actively seeking better jobs and/or investing in new skills.

A key to success of the work placement programmes rests with three broader principles, none of which appear to have been addressed by the policies put in place since the inception of the crisis.

First, selection mechanisms that determine who gets to participate in the programme must ensure that both the workers and the self employed are fully equipped for the challenges of the programmes. In the case of Fas-supported social welfare recipients programmes, the issue is whether the programmes actually select the best suited recipients with prior experience in the workforce.

Second, choice of businesses attracted into such programmes must be based on their ability to provide broadly marketable skills. Often, placement programmes box participants into jobs with firm-specific skills. Such programmes are only successful if they involve large and well-anchored employers. Even then, a restructuring or scaling down of Irish operations can leave these programmes participants with no transferable skills.

Third, the incentives to retain these participants in the labour force after the funding runs out must be put in place before the programmes commence. Clearly, absent a comprehensive reform of our social welfare system and minimum wage laws, this critical aspect of the programmes has not been followed through.

At this stage, there is no evidence that either Fas or any other body responsible for Ireland’s jobs support programmes have a comprehensive system of policy formulation and controls to assure that those participants who complete the programmes will not be once again drawn into the welfare system.


Box-out:

As was noted in this column last week, the stellar performance of Irish exports in 2009 was driven largely by the booming pharmaceutical sector, which posted a 12 percent increase in overseas sales in 12 months to December. However, the future of this sector is shrouded in uncertainty. Take the following major threats looming on the horizon. In Cork, Pfizer-Wyeth manufactures its blockbuster drug, Lipitor (with sales of US$12 billion in 2005 and rising since) for shipments to Europe, Middle East and Africa. Comes November 2011, Lipitor will face steep competition from generic manufacturers. The effect of Lipitor coming off patent protection is hard to estimate, but given Pfizer’s merger with Wyeth – some rationalisation globally will have to take place to justify high valuations of the combined firm. Out-of-a-blockbuster Irish operations might just be a convenient target. Roche-Genentech and Merck-Schering-Plough marriages are also facing some tough decisions on what to do with their existent older plants.

Of course, big pharma is not the only sector under pressure. Intel’s Leixlip plant last time saw investment in 2005-2006 under Fab 24.2 programme. Given life expectancies for semiconductor lines, the Leixlip facility is up for a new round of funding in the next couple of years. Or is it? To-date, IDA and Ireland-based MNCs were able to sustain high levels of inward investment to support renewal of the plants and product lines. However, as Dell’s experience shows, it takes only months for a US$15 billion manufacturer to pick up and move out of the state. It will take years to find a replacement.

Economcis 18/01/2010: Sunday Times 10/01/2010

The following article was published in the Sunday Times on Janaury 10, 2010. This is an unedited version.


Since the beginning of the current crises, through the abandoned economic policy programme of December 2008, to Budget 2010 our Government has been paying lip service to Irish exporters. The rhetoric, however, never matched the reality when it came to providing support for the sector.

Irish aggregate exports have performed in exemplary fashion through the downturn despite a number of very severe external shocks and some new internal bottlenecks affecting the sector.

Per latest CSO data, total Irish exports declined by only 1% in 2009: from 155.4 billion to €153.9 billion. In the mean time, Irish GDP has fallen by an estimated 7.5% and GNP collapsed by a massive 10.4%. And the role of exports in this economy continues to grow. In 2008, Ireland exports amounted to 99.5% of GNP, contributing 0.9% to our economic growth – the highest contribution in the year. Last year, the value of our exports rose to 116% of GNP, with exports accounting for an estimated 2.7% of the decline in GDP. Once again the best performance of all components to growth.

This stellar performance came at the time when external environment was rapidly deteriorating – in terms of both demand and overall trading conditions.

Over the course of 2009 as goods exports flows from 67 developed and middle-income economies have contracted by 23%, Irish merchandise exports were down only 1%. Two sub-sectors – pharmaceuticals and medical devices – have posted robust growth of 12% and 4% respectively over the course of 2009. Excluding these two sub-sectors, merchandise exports from Ireland (down 16% year on year) were still more resilient than overall world trade.

Credit and banking crisis had a direct impact on our trade. In the first half of 2009, Irish exports of services have experienced a severe contraction due to the collapse in international financial services activities. Only a strong performance by the business services and above-average performance by computer services have allowed for some recovery from this shock, with the value of overall services exported from Ireland falling just 1% to €68.4 billion over the course of full year.

Much has been written about devaluation of the dollar and sterling. The deterioration in our terms of trade vis-à-vis the rest of the world was indeed dramatic, contributing to a severe fall off in exports to the UK and Northern Ireland. Irish exporters also faced a significant shift in purchasing by the UK retailers away from Ireland. This was particularly noticeable amongst food and drink exporters – the sector that has the largest penetration by our indigenous companies.

Another factor much overlooked amidst financial markets turmoil was the drying up of the export credit facilities from the banks. Irish Exporters Association, other bodies and a number of economists, including myself, have for two years advocated the need for putting in place a meaningful programme of Government export credit guarantees. Per international data on trade credit flows, such programmes operate in some 57 countries These programmes are usually viewed as being low cost or even revenue-neutral. The risk to the Exchequer from guaranteeing a short-term credit for signed contracts for shipments is minimal if properly implemented and structured.

Initially, the Government has promised to allocate funding for the programme back in October 2008. By January 2009, its scale was cut to a meagre 1.5% of our indigenous exports. The plan was finally shelved just two weeks before Budget 2010 day. In place of trade credit supports, the Minister for Enterprise Trade & Employment has offered Irish exporters a promise to look into providing and ‘employment subsidy’ scheme. The Minister never explained what such a scheme can do for the exporters, nor how she arrived at the conclusion that a long-term jobs subsidy undertaking is less risky than a short-term export credit insurance. Of course, evidence from our European counterparts shows that jobs subsidies have virtually no positive impact on sustainable employment even at the time of robust jobs creation.

On December 1, just as Brian Lenihan was putting final touches to his Budget speech that contained sugary references to Irish exporters, the UK Government announced an extension to the Fixed Rate Export Finance facility through a specially-designated Export Credits Guarantee Department (ECGD). ECGD which also provides “insurance against non-payment risks and guarantees for bank loans to buyers of UK goods”, allows exporters to provide medium and long-term finance to their overseas buyers at fixed rates of interest. The rates charged under the scheme are established through the OECD, and are adopted by all major export credit agencies worldwide. These schemes are more risky than short term credit insurance rejected by the Irish Government.

Of course, the irony has it, Minister Lenihan also contributed to the exporters woes by placing a new charge on transport costs in the Republic and internationally via the Carbon Tax. This Government has already introduced one export-impacting tax back in October 2008. The so-called travel tax of €10 per departing passenger has now been linked to declining Exchequer revenue and the damages done to Irish tourism, hospitality and transport exports by a group of international transport economists, through my own analysis and Government-appointment panel of industry experts. With Carbon Tax we now have two measures that explicitly threaten our exports.

These policy contradictions set the stage for 2010.

Overall, 2009 marked the worst year on record for domestic food and drink exporters, as well as computer hardware and other manufacturers. Given that these sectors account for over 50% of the total exports-supported employment in the country, there is increasing urgency for enacting some meaningful support policies aimed at sustaining our export activities and employment. The idea that we first let companies sink on the lack of trade finance and then provide them with subsidised unskilled labour through employment support schemes run by our fabulously ineffective Fas, as the Government is suggesting, makes absolutely no sense.

Another significant concern for 2010 relates to the lagging imports by MNCs-dominated sub-sectors, such as pharma, medical devices and computer hardware. These sectors import majority of material inputs into their production from abroad and low imports relative to exports here suggest two possible trends.

Firstly, increased volumes of exports from some of these sectors in 2009 are most likely driven by record transfer pricing bookings through Irish operations. This is normal for any international operation in a recession, when companies scale back on capital investment and ramp up their tax optimization operations. While such developments have benefited Ireland in 2008-2009, continuation of these activities is not assured in 2010. Should there be a restart of global investment cycle (with some signs already pointing to improved capital investment in the BRIC economies and Asia), the incentives to book artificially inflated profits through Ireland will decline in relative importance.

Second, lagging imports growth shows that the MNCs might be unsure about the need to maintain high levels of inventories in Ireland. This in turn indicates the relative fragility of the expanded exports levels for these companies and puts overall Irish exports further at risk.

Lacking any real policy supports for the exporters, the Irish Government has resorted to the tactics of deflection and evasion. For example, in December 9, Minister for State with responsibility for international trade, Billy Kelleher TD was forced to defend the Government unwillingness provide exports credit insurance scheme proposals by referring in the Senad to Nama, banks recapitalization and even the nationalization of the Anglo Irish Bank.

In 2010, even the expected return to global growth in trade volumes is unlikely to push Irish exports beyond 2% annual growth mark, according to the latest forecasts from the Irish Exporters Association released this week. And even this forecast is predicated on continued improvements in Irish economic competitiveness and no further adverse changes in the euro position vis-à-vis other major currencies.

Instead of empty rhetoric, our exporters deserve a real chance to drive this economy out of the slump. Hoping that Nama will solve all of our problems simply won’t do.

Box-out:

Per latest CSO release, in Q3 2009, the gross external debt of all resident sectors in Ireland stood at €1,637bn or €51bn down on the Q2 2009 level. But, per same CSO release, the liabilities of Ireland-based monetary financial institutions (aka our financial system inclusive of IFSC) were virtually unchanged quarter on quarter at €691bn with their share of total debt rising from 41% in Q2 2009 to 42% in Q3. Similar dynamic took place in Other Sectors – comprising insurance companies and other financial enterprises, plus non-financial companies – where debt as of Q3 2009 stood at €618 billion or 38% of the total, up from 37% in Q2 2009. Direct investment sectors liabilities rose over the quarter by 2 billion and General Government increased. This implies that virtually all of the quarterly decrease in our indebtedness came from the Central Bank funds changes. This is why excluding the Central Bank and Government liabilities, total economy debt rose from 1.513 trillion in Q2 2009 to 1.508 trillion in Q3 2009.

But what the CSO and the media reporting on the figure didn’t tell us is since Q3 2007, the overall debt levels in Other Sectors rose by a cumulative of 15.6%, in Direct Investment sector by 9.3%, and our total debt rose by 8.33%. Only banks have so far managed to de-leverage in Ireland (down 9.8% on Q3 2007) thanks to the taxpayers’s cash. Which brings us to a sad but inevitable conclusion – while banks use our money to write down their bad debts, is it any surprise that the real debt burden in the Irish economy is not declining?

Economics 18/01/2010: Sunday Times 03/01/2010

A friend just highlighted to me that I have not posted my articles for Sunday Times since late 2009. In the next few post, I will correct for this omission.

First, unedited version of January 3, 2010. Note the box-out - covering very interesting development on Nama.

Over the last few weeks, a new consensus has emerged on the direction for Ireland in the New Year. Caught in the headlights of the Government PR blitz post-Budget 2010, the media and our quasi-governmental economic commentariate (Quagec) have firmly forgotten the simple fact that the bottom of the economic canyon we find ourselves in will require much more than a wishful New year’s resolution on behalf of the Exchequer. It requires a miracle of decoupling from our Euro zone’s sick twin – Greece – in real economic terms to restore full confidence in this economy.

Throughout 2009, our policymakers grumbled that Ireland was unfairly treated by international markets. As our CDS and bonds spreads were moving in tandem with those of Greece, the sop story from our Quagec was: “Ireland has a better starting position in terms of lower debt burden and it has taken the necessary pain. We are much closer to Berlin than to Athens.”

This, of course, was nothing more than economic gibberish dressed up to sound impressive. Past performance is no guarantee of future returns. It is the prospect of the future that is driving our risk valuations instead.

So what are the New Year’s prospects for our fundamentals?

The Greek Government is aiming for a 2010 deficit of 8.7% of GDP, although Greek parliament has approved budgetary estimate of 9.7%.

Ireland’s Exchequer deficit in 2010 is likely to reach 11.6% of GDP or nearly 15% of GNP, given the prospect for another year of a widening GDP/GNP gap. These stratospherically high numbers do not account for the cost of recapitalising the banks and for Nama. Should even a half of the estimated banks recapitalization costs hit the Exchequer in 2010, our public deficit is likely to exceed that of Greece by 3.7 percentage points in terms of GDP and up to 7 percentage points in terms of GNP.

Behind these headline figures there are other multiple reasons for the deterioration in our fiscal position in 2010.

Rising unemployment will persist through the first half of 2010, imposing new burdens on our already mammoth social welfare bill. These costs will be multiplied by the ongoing and accelerating process of unemployment benefits claimants transitioning onto full social welfare benefits as their supplementary savings and redundancy payments are exhausted.

Irish Exchequer, unlike its Greek counterpart, will be facing a multi-billion euro claim in terms of recapitalizing the banks. This bill is expected to reach above €10 billion for the six guaranteed institutions on top of the costs of Nama.

In 2009 Ireland-based multinational companies have booked massive transfer pricing profits through their Irish operations. 2010 might this activity collapsing. Over 2010, the US and Asia-Pacific region are expected to re-enter the economic growth cycle. Traditionally, this involves a restart of investment cycle. This, in turn, means that the firms will place much lower importance on maximising tax efficiencies via their off-shore operations. The risks for Ireland Inc here are slower inward investment and lower tax revenues, with many of the jobs pre-announced by the IDA in its recent report potentially delayed.

Looking forward, 2013-2014 will see Irish deficits still exceeding those in Greece, even if the New Year’s resolutions by Minister Lenihan are delivered on target. The latter, of course, is doubtful.

Firstly, all Budget 2010 measures announced by the Exchequer are gross, not net, implying that no more than roughly 80% of these can be achieved in real terms once second order effects and automatic stabilizers are counted in. Secondly, Government public sector pay reductions are now coming into doubt with Irish public servants facing a real pay cut of no more than 3-4% for top grade officials.

Getting back to the real economy. For 2010 our officials are forecasting a 1.3% decline in GDP and a 1.7% fall in GNP. The risk here is to further downside. Should Ireland-based MNCs divert their activities to investing in rebuilding their productive capacity in world’s faster growing economies, the GDP might fall by another 0.1-0.2 percentage points. Should housing prices decline another 8-10% as my estimates suggest, the wealth effect alone will shave off 0.1% from our annual output. Unless consumer spending improves substantially, we might be looking at 2010 producing a fall in GDP to the tune of 1.5-1.7% and a decline in GNP of around 1.8-2%.

But what can be the driver of consumer spending increases in 2010? Sky-high taxes and a promise of more taxation rises in 2011 delivered by Minister Lenihan on the Budget Day? Or a hope for continued historically low cost of borrowing?

Don’t hold your breath for the latter. Starting with the first month of Nama operations – which might come as early as February – Irish banks will be increasing the cost of adjustable rate mortgages. The unfortunate souls who hold these loans will end up paying 50-75 basis points more over the course of 2010, regardless of what the ECB might do.

With the ECB widely expected to raise rates in the second half of the year, we might be heading for 2010 ending with mortgage rates priced at around 100 basis points higher than they are today. A new wave of mortgage defaults will be in the making.

Once again, the Greeks are hardly at the races when compared to Ireland’s house prices collapse, or to our stock market crisis to date, or even to our expected mortgage defaults yet to hit the banks in 2010-2011.

The real indicator of stability of our economy compared to that of Greece is the extent of non-financial sectors debts. In Ireland, this figure currently stands at over €1.16 trillion (roughly $570 billion ex-IFSC). Comparable figure for the Greek economy is $35.4 billion – 16 times lower than for Ireland. Irish total gross debt (inclusive of IFSC) was $2,387 billion in Q2 2009 – some 430% the size of the Greek.

All of this goes to prove two things. Firstly, throughout 2009, rational investors operating in fully functioning bond markets were correct in discounting Ireland alongside Greece as the two weakest economies in the Euro area. Secondly, no matter what you might hear in weeks to come from our Quangec, we far from having passed our hardest tests in the current crisis.



Box-Out:

On Christmas eve, while the national news outlets were unrolling their festive medley of jolly carols and light entertainment, the Department of Finance has published a 2-page document, titled Nama (Designation of Eligible Bank Assets) Regulations 2009. The document’s objective was to define the assets eligible for transfer to Nama. Article 2 (a)-(d) state that Nama will be allowed to purchase at our, taxpayers, expense virtually any type of assets (short of credit card debts, but not personal loans or car loans) that are secured against some sort of development land asset. This covers pretty much every credit instrument known to man – from a plain vanilla loan to a structured credit agreement, all the way to a complex derivative contract. Even loans secured against equity shares in the undertaking to develop land, regardless of whether such an undertaking was primarily involved in property development or engaged in this activity as a side-show, will be eligible for taxpayers’ purchase. Undertakings that are eligible for such a treatment include not only plcs and established private businesses, but also opaque private partnerships and ‘over-night’ syndicates.

Take for example the infamous Glass Bottle site in Ringsend. The new edict means that the loans extended to developers and the investors engaged in a partnership, plus all the loans secured against the shares in the partnership and other concerned undertakings linked to the partnership, all and any other loans extended to anyone else who pledged as security any asset related to the site or its developers or investors are all eligible for the transfer.

In other words, the latest legal installment to Nama operational statues makes the state-financed bad bank a target for unceremonious dumping of all forms of toxic risky instruments from the banks balance sheet, regardless of claims seniority. And that, in turn, implies that Nama might end up holding conflicting security seniorities against itself. Good luck untangling that.

Not exactly a policy I would support

You can't accuse Ruskies of the lack of freedom of speech...

I wonder if this qualifies for Irish blasphemy law violation...