Economics 27/02/2010: How to reform our broken risk pricing system

This is an unedited version of my article in March 2010 edition of Business & Finance magazine:


There are several deeply rooted problems with the current analysis of the ongoing financial crisis. These relate to the sources of the crisis itself and to the solutions proposed for ensuring that a new financial bubble will not emerge out of the ashes of systemic risk under pricing that characterized the period of 2003-2007 around the globe.

So far, the public aspects of the regulatory responses to the crisis have been focused on ‘political’ topics, such as executive compensation. Fine: the incentive for banks executives to structure their own compensation to reflect short term gains is well established.

Political issues are non trivial as well. We all are aware of the fact that politicians – from Bill Clinton to Gordon Brown to Bertie Ahearn and on – have strong incentives to placate voters through fattened Exchequer revenue, expanded public spending and broadened access to credit irrespective of risks. Active encouragement of loose lending standards (especially in the case of the US SGEs: Fannie Mae, Freddie Mac and Ginnie Mae) were enshrined in regulatory and legislative mandates. And look no further than Greece, Portugal, Spain and Ireland as to the troubles this can cause – politicised spending breeding scores of vested interest groups that cannot be disentangled from the feeding trough.

All of these forces, underlying the crisis emergence, are well known. What is less frequently discussed in the media is that wrong incentives alone are not a sufficient condition for markets malfunctioning, since in efficient markets, a contrarian view should be able to price out those players aligned with wrong incentives.

It is a much deeper question as to whether this has happened in the case of the current financial crisis. Anecdotal evidence suggests that this was indeed so. Early in 2007-2008, a number of short positions, including those taken well in advance of the crisis, were generating the payouts consistent exactly with the rapid pricing-out of the malfunctioning lending strategies. Ironically, banning short sales has resulted in the restoration of the mis-aligned incentives in the market. An act by the regulators aimed at restoring order in the financial markets turning out to be nothing more than reinforcing the very causes of the crisis.

This means that we must look back beyond the immediate crisis to find any evidence to either support or dispute the proposition that mispricing of risks by the financial system was systemic (in the sense that existent models of risk pricing could not have allowed for contrarian pricing strategies).

It remains a puzzle that the main villains of the game, sub-prime mortgage packages (the famed ‘Collateralised Debt Obligations’), seem to have been so badly mispriced. This apparent mispricing lay not so much in the slicing of the mortgages but in the failure to price into the packages as a whole the apparent systematic risk due to the general response of property prices to the business cycle.

Suppose that the current view that greed blinded markets participants to the fact that CDOs packages were not properly pricing risks is correct. This explanation requires that not a single market participant was willing to take a contrarian strategy betting against the consensus view. Alas, this is patently untrue.

So ‘collective madness’ explanation does not hold and the crisis roots lie somewhere else – more likely, in the balance of incentives. My suggestion is that on the margin, regulatory and market incentives led to favouring of underpricing risks inherent in CDOs and MBSs. Thus, on the margin, excess returns to unpriced risk for going long on mortgage-backed products were made greater than the expected returns to shorting mortgage-backed products once the price of insuring / shorting these products was taken into account.

In other words, it was a combination of:

• Artificially low perceived cost of long positions;
• Artificially high cost of shorting; and
• Recklessly elevated correlations between product risk (mortgages risk) and insurer risk (AIG)

that drove the bubble formation. The reason why this understanding is important is the following:

If contrarian strategy could have been formulated based on existent risk pricing systems, then short sellers were ‘fundamentally’ justified in their positions and their gains were not ‘speculative’. Furthermore, this would imply that the current crisis is not systemic from the financial point of view, but is driven by incentives and regulatory failures.

If, however, existent risk pricing systems were not sufficient to support the contrarian investment strategy and those short sellers who were betting against the consensus obtained speculative profits, then the markets are not efficient and the crisis is systemic in nature.

So, if we take information about the markets available pre-August 2007, could the crisis been pre-priced? Put differently, were Irish or for that matter UK or US property and credit bubbles predictable on the back of fundamentals or were they random events?

The systemic crisis argument supporters show that since Irish property prices have indeed collapsed on the back of weaker-than-expected ‘fundamentals’ market price risk discounting has failed.

Those opposing the argument point out that the fundamental in the housing market is ultimately driven by income dynamics, which in turn are driven by productivity. In the case of Ireland, productivity growth (income growth) should follow a random walk because innovation is largely unforecastable and in the case of a small open economy it is also subject to global trends. In other words, Irish productivity growth should be following a random walk that is even ‘more random’ than the productivity growth processes in the rest of the world.

Both are wrong. It turns out that close to the crisis – at least from 2003 on – Irish property prices appeared to become a non-stationary process having been largely stationary in the previous decade. Ditto for the US and UK, and even Spanish, Russian and Dutch property prices.

This means that the conditional forecast of the property prices in Ireland was best modelled by a reference to the current prices. More importantly, from the point of view of risk pricing, expected conditional volatility of house prices was a scale factor of the observed current volatility. In other words, the degree of risk 6 quarters from, say February 2003 was simply 6 times greater than very low volatility observed back in February 2003.

The scaling relationship, alas, failed to hold in the real world. As the property boom became, using Bertie Ahern’s terminology, ‘boomier’ through 2003-2006, property prices stopped following non-stationary process and their volatility became largely trend driven. The trend presence means that at least in part, future risk could have been priced into lending decisions by the banks and regulators. Alas, it was not. All evidence on lending suggests that the banks lending margins were heading down during 2003-2008 period, not up. In other words, Irish mortgage lenders, with tacit consent of the regulators, were pricing in decreasing risks into the future during the bubble inflation time. Ditto for all other countries that have experienced the collapse of property markets.

So whilst the financial markets were correct in pricing risks, subject to significant regulatory incentives constraints that skewed their willingness (and later ability) to actually adjust their risk pricing positions, mortgage lenders and regulators were grossly mispricing risks. This realisation leads to two major conclusions.

It shows that globally, financial crisis of 2007-2010 has been driven by the risk mis-pricing that originates in the very institutions whose business is preventing this from happening – the banks and the regulatory bodies.

And it shows where the future reforms attempting to address the issue of financial bubbles formation must lie. And it certainly has nothing to do with bankers compensation packages. The main solution to the problem suggested today is heavy re-regulation of bank risk; moving Basel I and II up to Basel III to include a pro-cyclical risk capital provision.

While a useful idea, greater buffer reserves of risk capital built over the years of credit expansion cycle, are not a panacea to the problem outlined above. The reserves are only sufficient in so far as they reflect actual risk expectations. Missing risk forecast will, in the end, still imply sub-optimally low levels of capital.

Instead, the answer to the problem of how can we prevent future bubble formation similar to the one that has been deflating since August 2007 lies in a more holistic approach to risk pricing reforms. This approach must involve several policy changes along the following directions.

Firstly, a more transparent early warning system must be deployed across the financial markets that would make short trading positions a part of open market pricing mechanisms. Put more simply, short trading must be allowed to operate on unrestricted basis, but all short trading positions must be disclosed and reported in the market in the same way in which we current disclose long positions.

Secondly, property must be treated as investment instrument, with full price and hedonic information disclosure rules mirroring those required for liquid financial instruments under MiFID.

Thirdly, there must be a clear set of strict ‘no pain, no bail out’ rules that will impose severe penalties on the management, bondholders and shareholders in financial institutions seeking public assistance. If countries can change governments within weeks after elections, banks can be weeded of their failed management as a matter of months. Instead of restricting their pay, in the future, we must make bankers accountable for their failures.

Third, regulatory authorities must be beefed up with independent, fully protected risk analysis boards drawn across the broader economy. These boards must be politically unconstrained, free of interest groups influence and must be operated behind a strict Chinese Wall relative to the entire regulatory process. A formal requirement must be imposed that at least 1/3 of the board members should be drawn from outside financial services sector, with the same proportion of members being required to hold a publicly verifiable policy positions that are contrarian to the consensus.

What the current crisis has taught us is that in the environment where politicians and industry drive risk pricing-related policies, failures of the market to cope with distorted incentives and incomplete regulatory oversight will be spectacular. Crises are a natural way for the markets to reassert proper order on inept regulatory and institutional systems.

Economics 27/02/2010: Double dipping

As of recent days, the media has become finally aware of the serious risk of double dip recession - here in Ireland (qualified below) and in the rest of the world. The reason for this awareness is most likely the ongoing crisis in the Euro area debt markets. But the real cause for concern should be the overall markets dynamics.

First, let me qualify what I mean by the double dip recession in Ireland. Officially, to have a double dip you must exist the first recession - which can only happen if Irish economy were to post at least a quarter of positive growth. There is an inherent asymmetry in the way we term the business cycle. While going into a recession requires two consecutive quarters of negative growth, recovery set in after just one quarter of positive growth. The second dip for a recession, however, requires again consecutive two quarters of negative growth.

Which, of course, means that were recoveries distributed following the same probability distribution as recessions, the risk of a double dip recession will be lower than the risk of a single quarter negative adjustment post-recovery. And lower still than a recovery. Statistics bear this out, with double dip recessions being relatively rare.

Of course, for Ireland, a double dip recession in current environment will simply mean that instead of turning first positive, then negative again, our GDP (or as I would prefer to measure it - GNP) growth turns more negative than it currently stands.

Definitions aside, what we do currently know points to a strong probability of a double dip recession in the US. Here is why.

As I pointed out in a recent article in the Sunday Times (here) I argued that residential investment is the leading indicator for both recessions and expansions. What we are now seeing the US and the UK are the first signs of renewed problems in this sector, as stimulus and tax breaks wear out.

• Resales of U.S. homes and condos fell 7.2% in January to the lowest seasonally adjusted levels in seven months. This marks two consecutive months of falls that ended an H2 2009 rise. Sales of existing homes have fallen two consecutive months after rising steadily through the fall on the back of a federal subsidy for first-time home buyers. Inventories of unsold homes fell 0.5% to 3.265 million, or 7.8 months of supply at the current sales pace. And this does not bode well with Irish data, where declines in inventories (see Daft.ie latest reports) were seen as an 'improvement' on the overall trends.
• Sales of new homes in the U.S. fell in January to the lowest level on record. Sales were projected to climb to a 354,000 from an originally reported 342,000 rate in December, according to the median estimate in a Bloomberg survey of 72 economists. The supply of homes at the current sales rate increased to 9.1 months, the highest since May 2009. Purchases of new homes reached an all-time high of 1.39 million in July 2005. January 2010 sales dropped 11.2 percent to a seasonally adjusted annual sales pace of 309,000 units, the lowest level on records going back nearly a half century.
• Foreclosures are continuing to rise and with them - banks failures (see a good post on US banks weaknesses here).

So overall, the US lead indicators are pointing to a double dip.

Ditto for the UK, where home prices are now hitting the reversals of recent gains. Average house prices in the UK fell 1% in February after nine consecutive monthly increases. Although average prices in February were 9.2% higher than in February 2009, according to the Nationwide Building Society, it is the dynamic, not the levels that matter.

And EU economies are now in the reversal as well:

• Confidence among German corporates contracted unexpectedly in February, according to the sentiment index released by the Ifo Institute - winter weather is being blamed, but there is little evidence this is really what is happening on the ground with exports tracing consumer demand downward;
• Italy's state-financed ISAE published a new survey showing that Italian consumer confidence is now in a free fall once again;
• Exactly the same is happening in France, where consumer spending is falling as the state cash-for-clunkers program ended, causing decline in car sales;
• Bank of France data shows that credit to the private sector have slowed down even further in January, while credit to companies was actually falling once again.

Since France and Germany led the Euro area out of recession last summer . That recovery was driven by government stimulus programs and a pickup in global trade. Domestic consumers, meanwhile, were left holding the bag - as usual - in the block which prides itself on selling premium stuff to foreigners and keep its own citizens as savings-generating serfs of the exports-driven economies. Net result? Q4 2009 Germany's GDP growth was flat in quarter-on-quarter terms.

This, of course, is bad news for Ireland. There are three major problems that lay ahead of our recovery and none are being helped by the weakening global economic climate.

First, there is a problem of fiscal deficits financing. Slowdown in the EU and US means that there will be no easing in the glut of new bonds issuances this year. Euro area alone is expected to raise its debt issues to roughly $2 trillion worth of bonds since the beginning of the crisis. A minnow, like Ireland, is bound to see its yields shooting straight up if we are to finance our deficits through open market placements. And there is no hope for placing these bonds elsewhere, as the ECB is hell-bound on clawing back on its quantitative easing programmes of 2009.

The ECB can do so in two ways - hike the rates, or reverse collateral inflows back into the banks. Alas, the former is out of question for now, with economic situation deteriorating. This leaves the latter as the only option. Irish banks - the most dependent on ECB lending throughout the crisis - will suffer heavily through such an exercise.

Second, EU growth reversal spells the end of our exports buoyancy and the hopes for foreign investment boost from the US MNCs aiming for EU presence expansion.

Third, absent growth in the Euro area, the markets will continue scrutinizing closely public finances of the member states. I will post on this issue later today/tomorrow, but the core message here is that Ireland is simply not in a very good position to escape severe downgrades from the markets, given the fact that our policies to-date have been heavy on squeezing all liquidity out of the households.

Economics 26/02/2010: EU Commission decision on Nama

The EU Commission has granted its nod of approval to Nama (here). The Note states that:

"The Commission has found that the establishment of NAMA constitutes state aid to the participating institutions pursuant to Article 107(1) of the TFEU, but that this aid is compatible by virtue of Article 107(3)(b)."

It is therefore clear that Nama is a form of aid. If so, who are the logical recipients of such aid - and there simply has to be someone benefiting from aid. How does this square against the Irish Government repeated statements that Nama is not a rescue plan for either the bankers or the developers.

"The scheme and intended operations of NAMA are in compliance with the guidelines set out in the Commission's Communication on the treatment of impaired assets (see IP/09/322 ) as regards disclosure and ex ante transparency, eligibility of institutions and assets and the alignment of banks' incentives with public policy objectives."

Emphasis above (mine) relates to the following issues:

• Transparency: what transparency does the Commission have in mind, given that Nama is set to report only to the Minister for Finance and will operate under the veil of total secrecy, outside constraints of public scrutiny?
• Alignment of banks' incentives with public policy objectives: does the Commission seriously think that incentives for the banks to repair their balancesheets through increased lending margins and higher costs, or reduced competitiveness in the banking sector due to Nama subsidy to select banks, or the need for recapitalization by the taxpayers post-Nama constitute properly aligned incentives for the banks to act in the interest of the public?

"In particular, the Commission has found that the scheme includes an adequate burden sharing mechanism through the payment of a transfer price which is no greater than the assets' long-term economic value, and the inclusion of an adequate remuneration for the state in the rate used to discount the assets' long term economic cash flows."

Of course, when the Commission is talking about public policy objectives, what they mean is the alignment of the scheme incentives with the principles outlined by the Commission. In other words - by focusing on the erroneous objective of ensuring long-term economic value consistency of valuations, the Commission is confusing public interest (interest of ordinary Irish taxpayers) with its own interest (interest of the Brussels to see compliance with its own regulatory framework, which in itself is a simple deus ex machina for concealing the reality of this state aid).

"Today's approval concerns only the NAMA scheme. The Commission will assess the compatibility (and, in particular, the actual transfer price) of the transferred assets when they are separately notified by the Irish authorities. These individual reviews will include a claw back mechanism in case of excess payments."

This is significant as it introduces a new layer of uncertainty for the banks - post-Nama, the banks will remain exposed to the Commission decision on valuations, which in effect will extend Nama process indefinitely, delaying any potential positive effect of Nama.

"Finally, the Commission relies on a number of commitments from the Irish authorities to ensure that NAMA, whilst it performs its goal of maximising the recovery value of the purchased assets, does not lead to distortions of competition through the use of some of the specific powers, rights and exemptions granted in the NAMA Act."

What are these commitments?

In short, the Commission decision on Nama is as holes-ridden as Swiss cheese and signifies a simple pro-forma sign-off on the scheme.

Finally, in his response to the Commission decision, Minister Lenihan stated that:

"Within the [Nama] valuation methodology a higher remuneration risk margin and higher enforcement costs will be applied. There will however be a reduction in the interest rates used for loan discounting purposes. "

This is significant as well, as a reduction in interest rates implies that the long term economic value valuations will have lower rate of discounting to the present value, thus leading to higher rates of over-payment on the loans. In other words, to keep discounts on assets artificially lower, the Government simply can reduce the cost of capital and increase real return on assets by 'cooking' up lower discount rates.

Of course, one must ask Minister Lenihan why exactly does he (or Nama) envision that the interest rates are going to be lower in the future. I know of not a single forecast out there that envisions the yield curve pointing down in the future.

Economics 26/02/2010: Euro area growth - leading indicators

Eurocoin - leading indicator for growth in the euro area is out today, so it is time to update the forecasts:
Last month, my forecast for Eurocoin indicator was to decline from 0.78 to 0.74 over February-March. The actual outrun was the decline to 0.77. So I stick to my forecast for further deterioration. All signs are pointing in the direction of the recovery being reversed - from exports to industrial production, to consumer confidence. And the global economy is starting to feel the pressures of fiscal unwinding. Ditto for the Euro area countries, where Greece and Spain are now at the forefront of fiscal pressures, while France and Germany are also feeling the heat.

This is consistent with low rates of growth, if not an outright double dip in economic activity. For now, I am still happy to stick to 0.6-0.7% annual growth rate for the Euro area as a whole for 2010.


On a related tone, but different geography, UK house prices are down 1% in February per Nationwide Building Society, reversing 9 consecutive months of growth. The end of stamp duty holiday is to be blamed, as well as poor weather. But in my view, the reversal is a sign that absent stimulus (tax or spending) there is simply no fundamentals-justified demand in the market.

Economics 25/02/2010: European economy and EU Commission

"Curiously enough, the only thing that went through the mind of the bowl of petunias as it fell was Oh no, not again. Many people have speculated that if we knew exactly why the bowl of petunias had thought that we would know a lot more about the nature of the Universe than we do now." The Hitchhiker's Guide to the Galaxy.

Indeed. Today's ECFIN weekly newsletter said it all. Titled cheerfully "ECFIN e-news 8 - EU interim economic forecast: fragile recovery has begun" it featured the revised interim forecast for EU economy from the EU Commission. It turns out, per forecast that (unbeknown to most of us in the real world) "the longest and deepest recession in EU history came to an end as real GDP in the EU started to grow again in the third quarter of 2009." This comes despite the fact that growth actually fell (and almost reached back into negative territory) in Q4 2009. Thus, in line with Commission optimism, Brussels now expects "seven largest EU Member States, ...to expand by an anaemic 0.7%".

"Weaker housing investments and continuing balance-sheet adjustment across sectors are expected to restrain EU growth in 2010. Unemployment remains on the rise and would thus dampen private consumption as well. Inflation projections remain largely unchanged at 1.4% and 1.1% in the EU and the euro area respectively".

I am not sure if this rather gloomy prospect matches the headline, but the same issue of the newsletter contains another piece titled "Rebound in economic sentiment slows in February". So can someone explain to me, please - is it that the recovery has begun, or is that the recovery is running out of steam? Clearly, I would tend to believe the second one, since it is based not on projections by the Commission (which famously predicted, and actually planned for overtaking the US in terms of productivity, economic growth and economic wellbeing by 2010, moved to 2012 and later to 2015), but on hard data.


In February 2010, the EU's Economic Sentiment Indicator (ESI) rose by statistically insignificant 0.2% to a still-recessionary 97.4. ESI was down to 95.9 (-0.1% on January) in the euro area. The latter correction follows an unterrupted climb up over 10 months, suggesting that the growth momentum might have been exhausted.

February reading of the Business Climate Indicator (BCI) for the euro area rose for the eleventh month in a row. Happy times? Not really - the relatively low level of the indicator suggests that year-on-year industrial production in January 2010 was still contracting, not expanding.

Drilling deeper into data: all sub-components of the confidence indicators remained below growth levels in January and February 2010. And one - retail trade confidence indicator actually reversed back into contraction territory after December when it crossed over the growth line. Employment conditions in services have turned negative again in January, as did construction confidence indicator.

Which part is showing that the recovery has begun, I wonder?

May be, just may be - the business climate is improving somehow? Well, not really:
EU Commission own BCI is still stuck at -1 - below expansion levels.

Consumers picking up, then? Nope: "In February 2010, the DG ECFIN flash estimate1 of the consumer confidence indicator2 for the euro area signals the first fall after 10 months of improvement (down to -17.4 from -15.8 in January). Confidence declined also among EU consumers, but to a lesser extent (down to -13.6 from -13.1 in January)."


So: consumers are down, producers are in the red and overall economic indicators are turning South again... yet 'recovery has begun'.

A bowl of petunias signalling the nature of the Universe from its Brussels windowsill.

Economics 25/02/2010: Wholesale prices - deflation is still a problem

Wholesale and Producer prices are out today for Ireland, January 2010.

Per CSO: Monthly factory gate prices are up 1.5% in January as compared to 0.4% rise a year ago. Annual percentage change now stands at -2.8% in January 2010, compared with an annual decrease of 3.8% in December 2009.

Exports prices rose strong 2.0%, while the index for home sales was down 0.2%. In the year there was an increase in the exports price index of 3.3%, primarily due to positive currency movements and a decrease of 0.9% for domestic sales prices.
Producer price deflation is moderating
but this moderation is driven primarily by external factors.

January 2010 most significant changes were:

• Basic chemicals (+4.9%),
• Pharmaceuticals and other chemical products (+1.7%)
• Other food products including bread and confectionery (+1.4%),
• Beverages (-0.3%)
• Building and Construction All material prices increased by 0.9% in the month

On an annual basis:

• Basic chemicals (-9.6%),
• Office machinery and computers (-4.1%),
• Radio, television and communication equipment (-3.7%),
• Other food products including bread and confectionery (+1.8%)
• Tobacco products (+7.8%)
  
• Building and Construction All material prices -1.4% in the year since January 2009.

Capital goods – a very important driver for recovery, posted a yoy price drop of 0.6%, and a mom rise of 0.4%. Thus, mom changes were too weak to signal any significant turnaround in business investment cycle.

Wholesale price of Energy products fell 3.9% in the year since January 2009, while Petroleum fuels increased by 24.1%. In January 2010, there was a monthly increase in Energy products of 0.8%, while Petroleum fuels increased by 2.7%.

Overall, therefore, while some moderation in deflation at wholesale level is evident, there is not enough momentum to suggest that we are out of the woods yet. Chart above clearly shows that the deflationary trend prevalent since May 2009 was broken in December 2009 and the positive trend has accelerated in January 2010. It will require 1-2 months of continued upward trend to signal sustained movement toward a recovery and the risk here is for a double-dip.

The same stands for Industrial producer prices (Manufacturing). But there is far less optimism in the numbers for Capital goods, which show more volatility and reversals than broader indices.

Economics 25/02/2010: Exports under pressure

A quick note on Ireland's trade flows for December 2009 - published yesterday.

As I warned earlier, the stellar performing Chemicals (inc Pharma) sector is now starting to retreat. Exports of Chemicals are down 9.54% in November and, per CSO statement, went further down in December. Machinery and Transport Equipment is down 38.9% in November (year on year).

Charts below illustrate the problems and showing the trends:
Overall, exports are down and the trend is also down - there goes a hope of exports-led recovery (not that it makes any sense, to be honest, given the global trends for trade). Imports are again heading South - suggesting two things:

• a renewed pressure on consumer demand side; and
• continued weakness in imports of intermediate inputs by the MNCs (signaling potential further declines in exports as a result).

Trade balance is not improving despite imports fall-off. There is a clear flattening out of the upward trend, suggesting that we are now close to exhausting the stage when collapsing demand drove trade balance up. It is down to exports from here on to influence the trade balance and the signs are pretty poor.
Chart above shows that the adverse changes in exports are not coincident with changes in terms of trade which continue to improve since Summer 2009. However, as the next chart clearly indicates, we are now away from the historic relationship between exports and terms of trade:
This implies that decline in exports we are experiencing is driven by other factors. Might it be a longer term pressure on MNCs activities in Ireland? Global trade flows changes? Or both?

Either way, there is no sign of exports-led growth. Irish exporters have performed miraculous well in 2009, compared with the rest of this economy. But one cannot hinge all hopes, as the Government is doing, on exporting sectors. Even more importantly, one cannot take exports performance for granted (as our Government is doing as well) - we need coherent strategy to get exporting back onto its feet.

Economics 24/02/2010: What's heading for Nama land

On a serious note - good post by Gerard O'Neill here.

On a lighter note: wanna see one Nama-bound investment courtesy of Anglo Irish Loose Loan Giveaways?

Check it out here - replete with grammatical errors and misspellings in the text. 'Autentik' stuff...

Since Anglo holds the loan and we (taxpayers) hold Anglo, I wonder if being an Irish taxpayer qualifies one for a free drink in this place.

Economics 24/02/2010: Greeks, Germany and the euro

There is a fine mess going on in Athens. And it is both

• detrimental to the Euro; and
• predictable (see here).

Exactly a month ago to date, I have predicted that Greece is going into a Mexican standoff with EU. We now arrived at exactly this eventuality (see this link to a good summary of Greek Government views - hat tip to Patrick).

Back on January 24th, I wrote:

"The EU can give Greece a loan – via ECB... But the EU will have to impose severe restrictions on Greek fiscal policy in order to discourage other potential would-be-defaulters today and in the future. That won’t work – the Greeks will take the money and will do nothing to adhere to the conditions, for there is no claw back in such a rescue.

Alternatively, the EU might commit ECB to finance existent Greek debt on an annual basis. This will allow some policing mechanism, in theory. If Greeks default on their deficit obligations, they get no interest repayment by ECB in that year. ...but what happens if the Greeks for political reasons default on their side of the bargain?

If ECB enforces the agreement and stop repayment of interest, we are back to square one, where Greece is once again insolvent and its insolvency threatens the Euro existence. Who’s holding the trump card here? Why, of course – the Greeks. And, should the ECB play chicken with Greeks on that front, the cost of financing Greek bonds will rise stratospherically, and that will, of course, hit the ECB as the payee of their interest bill.

Thus, in effect, we are now in a Mexican standoff. The Greeks are dancing around the issue and promising to do something about it. The EU is brandishing threats and tough diplomacy. And the problem is still there."

There are three possible outcomes from the standoff:

• Greece backs down and Germany accepts an apology - which pushes us back to square one, with Greeks still in the need of funds and EU still without a plan;
• Greece goes for the broke and remains within the euro, implying a rapid and deep (ca 30%) devaluation of the euro; or
• Greece is forced out of the euro (there is, of course, no mechanism for such an action).

The first option is a delay in the inevitable; the last one is an impossible dream for fiscally conservative member states. Which leaves us only with the second option.

And incidentally, the only reason German bunds are still at reasonably low yields is because Germany is linked to Greece (and other PIIGS) only via common currency. Imagine what yields the German bunds might be at if a full political union was in place?

This, of course, flies in the face of all those who preach political federation as EU's answer to structural problem of hinging desperately diverse economies to common currency.

So hold on to your pockets - after the Exchequer raided through them via higher taxes; Greek default will prob their depths through devaluation. And then you'll still be on the hook for our banks claiming their share in an exercise of rebuilding their margins.

Economics 24/02/2010: Ireland and EU16 Competitiveness

Charts below show our relative competitiveness, as measured by the harmonized competitiveness index (HCI) based on consumer prices (CPI) and reported by the ECB.

Charts 1-3:

Despite massive deflation, compared to the rest of Euro area, Irish economy has managed to record only a small improvement in HCI (CPI) of 1.57%, while the Euro area recorded an improvement of 2.22%.

Charts 4 and 5 show the latest data for harmonized competitiveness indicator based on GDP deflator.

Charts 4-5


Once again we are not in a very good club, folks. And another worrying thing – we are not at the competitiveness gains game anymore either. Table below illustrates

Figure 6

After Q1 2009, we stopped gaining in quarterly change in competitiveness and instead moved into positive territory – signaling deterioration in competitiveness. Net positive – we did so at a slower pace than the Euro area as a whole. But does this help much, when you consider that we are the third sickest economy by this measure in EU16 after Luxembourg and Spain?

So, ok, may be labour costs adjusted for productivity help us in our quest for competitiveness. After all, we do have pharma and medical devices sector here that is performing miracles when it comes to transfer pricing-backed growth in output per worker? And the two sectors weathered the storm of the crisis pretty well so far.

Charts below illustrate:

Figures 7-8
Not really. Harmonized competitiveness index based on unit labour costs also shows us to be the weakest point in the Euro-land chain. And it also shows that in Q3 we have gone into reverse when it comes to gaining competitiveness. We are now pulling away (once again) from the Euro area average.

All of this is instructive – for all the robust talk about Ireland gaining in competitiveness, restoring our advantageous relative position compared to EU counterparts, real data shows we are now getting economically-speaking sicker, not healthier… Time to start thinking about changing our policies, anyone?

Economics 24/02/2010: Wages, Euro and the crisis

Per latest ECB data, Euro area wages grew by 2.1% in annualized terms in Q4 2009, despite the economy remaining near zero growth and despite the fact that any recovery is tenuous at the very best. In the entire period of the current crisis, wages in the Euro area have shown no signs of declining. Two charts below illustrate the point that Euro area economy is not gaining any competitiveness when it comes to labour market.
This pretty much means that we are now boxed into the situation where medium term devaluation of the Euro is a requirement.

Oh, and when it comes to Ireland - see for yourself - chart below combines ECB data with the Central Bank of Ireland data on Average Hourly Earnings Index in Manufacturing:
We really are in a league of our own...

Economics 23/02/2010: IMF on some of the Irish crisis policies

So we keep hearing how the entire world is applauding the Irish Government for doing "the right thing" (as Minister Eamon Ryan asserted today on Prime Time). Hmmm... I guess IMF isn't amongst the 'entire world' set.

IMF paper released today, titled "Exiting from Crisis Intervention Policies" states:

"For most advanced economies, including the very largest ones, fiscal stimulus vis-à-vis 2008 levels will be broadly maintained in 2010.

Among G-20 advanced economies, only Canada and France are expected to start a significant adjustment—on the order of ½ and 1 percentage point of GDP in 2010, respectively, in terms of their structural balance.

Larger reversal of stimulus is expected in Spain, and especially in Iceland and Ireland, but from very high structural deficit levels in 2009."

This doesn't sound like an endorsement, just a clinical admission of the fact, but... notice the words 'reversal of stimulus'. This really implies that the IMF is treating our cuts imposed in the Budgets 2009, 2009-bis and 2010 as being largely cyclical (consistent with a reduction in a temporary stimulus).

Of course, the IMF - as well as any reasonably literate macroeconomist - would like to see Irish government (and other governments as well) cutting structural deficits, not cyclical. And the IMF makes this point by stating:

"Few G-20 advanced economies have so far developed full-fledged medium-term fiscal adjustment strategies, although some have announced medium-term targets or have extended the horizon of their fiscal projections.

A notable development is the adoption by Germany’s parliament, in June 2009, of a new constitutional fiscal rule for both federal and state governments that envisages a gradual move to (close to) structural balance from 2011. The rule requires the federal government’s structural deficit not to exceed 0.35 percent of GDP from 2016. States are required to run structurally balanced budgets from 2020."

Might it be the case the IMF views our cuts as being at risk of turning out to be short-lived? It might.

Another interesting feature of the report is the following statement (which comes right after the Fund saying that it expects the governments to start lifting banks guarantees since funding conditions have been easing):
"Deposit insurance schemes have not undergone any significant modifications since their expansion at the beginning of the crisis. The average duration of schemes is about three years. Since June 2009, New Zealand and the United States (for transaction accounts) adopted changes and extensions to their programs, including a rise in participation fees to better reflect market prices and risks."

Now, give it a thought: the Government has extended banks guarantee, but cut the deposits guarantee - exactly the opposite of what other governments are doing. Another uniquely Irish way of 'doing the right things' for the banks and taxpayers?

Doubting? Take IMF's data for the extent of support we have given the banks to date:
Do remember - the above figures for Ireland do not include the full exposure due to Nama and the latest stakes-taking exercises the Government is engaging in with BofI and will be engaging in with AIB in three months time. Notice just how massive is our exposure relative to GDP when compared to two other crisis-stricken countries - Denmark and the Netherlands. Also notice just how much more aggressive these countries are in writing down their banking systems' bad debts? In fact, not a single country comes close to us in terms of engaging in bad assets purchases from the banks. Why? They do not believe in the 'long term economic value' that Nama is based on?

Another interesting table from the paper:
This, of course, shows that majority of countries out there are completing their programmes for stabilisation of the banking sectors in 2010-2011 period. Ireland is not at the races here. Unlike majority of our counterparts, we are bent on dragging out Nama through some 15 years worth of the zombie banking, zombie development and zombie economy - Japan-style. Except, unlike Japan, we have young population.