Economics 27/03/2010: Breaking News: AIB and FF/Government

Major news breaking in the media rooms:
AIB (the first story below)
RedC Poll (the second story below)


Story 1:

The first story is about the leaks reported by Newstalk (see here) that AIB will announce before opening of trading on Monday that the state will be taking a 65% stake in the bank.

Per senior source in the Dail (hat tip to B) - the reason for AIB guiding 65% ownership now is that in addition to Nama haircuts, they are, allegedly, seeing significant deterioration in the sub-€5mln loans (the loans below Nama-eligible threshold).

This is hardly surprising. Since May 2009 I have consistently supplied estimates as to the eventual state ownership in both AIB and BofI. Depending on various scenarios:

• assumed Nama haircuts,
  
• the actual current risk weighting on the loans being transferred,
  
• share price at the time of announcement and
  
• the willingness of the banks and the Government to recognize future expected losses on the loans not transferred to Nama

RVF approach to valuing AIB and BofI balancesheets suggests that at the end of the current crisis, the state will outright own around 85-90% of equity in AIB and 50-60% in BofI. This eventual outcome, for political reasons, will come in two stages:

• post-Nama injection of capital (with AIB placing around 60-70% of its equity with the State and BofI placing around 40-45%), plus
• second stage recapitalization to correct for continued deterioration in the books over 2010-2011 (adding another 20-30% of equity for AIB and 10-15% for BofI)

The problem with this two stage recapitalization is that the taxpayer will end up paying three times for the same equity:

• Having injected €7 bn into two banks at the time when they were worth less than €2.5 bn for the entire lot,
  
• we are now be left on the hook for some €20 bn worth of largely worthless loans - to be purchased at ca 30-40% discounts (against the real market discount of 65-90%),
  
• plus €7-8 bn in fresh capital post-Nama
• plus the margin of ca 10-15% for further deterioration in non-Nama loan books (requiring another €7-9 bn of fresh capital).

Thus the Irish state is now likely to use up to €20 bn to buy up equity and loans from a bank that is currently worth around €1.5 bn... In the world of finance, even the most reckless bankers never managed such margins.

Alternative: force banks to acknowledge the full extent of their expected losses (as Swedes did in the 1990s), then force them to take the bondholders and equity holders to the cleaners (as Swedes did in the 1990s), and only then take equity - or in effect, take full equity in the banks. The cost for AIB would be around €10-12 bn, depending on how deep of a haircut on senior bondholders the banks can impose.

Story 2:

Tomorrow's RedC poll

Here is a preview - as was supplied to me by my sources (a disclaimer is due here: these are as provided by the source, so check tomorrow's papers for actually confirmed figures). Parties support:
The poll was conducted on Monday-Tuesday, so it does not reflect change of opinion in the wake of Cabinet reshuffling and the dissident TDs comments. Both factors can be expected to contribute to further decline in FF ratings, speculatively pushing core FF support post-Thursday to 21-22%.

Some specific questions:
“Brian Cowen understands people like me” - 31% agree
“Brian Cowen is a good Taoiseach” - 27% agree
“Brian Cowen is a safe pair of hands” - 31% agree
“Brian Cowen is the man to lead us out of recession” - 29% agree

Hat tip to NN.

I wonder what the same punters would say about our leaders now, after the reshuffle debacle and the open dissent amongst the back-benchers.

Economics 26/03/2010: National output figures

Held back by work, I am only now catching up with data released this week by CSO, so do stay tuned - these pages will be featuring more analysis in days to come.

First, QNA for Q4 2009 came in, putting annual decline in GDP at 7.1% for 2009 and GNP at a whooping 11.3% (per table below):
This is slightly better than my predicted annual declines of GDP to the tune of 7.3% and GNP to 11.5-11.7%. Nonetheless, as CSO admits, these figures mark historical record of declines.

Throughout the year, I have traced the paths for the main QNA series in charts. A picture, after all, is worth a thousand words. So here they are, updated for the latest figures:

The first chart above shows GDP and GNP time series. Two things are apparent from these figures: first, all three series peaked at the same time - in 2007. This is significant for as we shall see below, the same does not hold for growth rates. Second, notice how factor cost-based GDP is showing more mild downward trend than market prices-based GDP measure? This suggests that deflation (market prices change) has been so far much more significant than declines in factor costs. This does not really bode well for our hopes of improving our competitiveness through this cycle.

Next chart shows components of GDP and GNP:
Notice how two state-supported sectors - public sector and agriculture (the latter supported, of course, via CAP) show no signs of a recession? Both are having jolly good time - courtesy of taxpayers (Irish and European). Also, do keep in mind that some of the public sector activities fall into other categories - e.g. transport was probably supported by the semi-state companies and their ability to ignore recession when it comes to hiking prices and charges (DAA is one good example here). So in real terms, private sector activity in each one of these sub-sectors is down by more than the CSO aggregates suggest.

Next chart illustrates another historic record:
The gap between our MNCs-dominated exporting economy and our domestic economy is now at historic highs - reaching 23% in 2009. This means that almost a quarter of what Ireland claims to produce (GDP) is really an accountancy trick and has nothing to do with this country. Of course, for years we have been conditioned to think that we are filthy rich because our GDP is so high. Oh, how deep the fallacy runs.

Now, think about the core metrics of state solvency deployed in international markets. Take our national debt. At current €77.6bn (per NTMA) it officially stands at just 45.6% of our GDP (46.2% if we are to use more time-consistent estimate from Finance Dublin). In the real world, this figure should reflect our real national income, for we can't seriously expect the foreign MNCs to be responsible for Ireland's debt. So the real figure should be 55.5% of GNP. Almost a 10 percentage points spread.

Now, let's take our current position and take a peek into the future. Suppose we take last 6 years' average growth rates for respective series. How long will it take for our various measures of income (bogus GDP and more honest GNP) to bring us back to the prosperity of 2007?
As chart above illustrates, should our MNCs continue racing ahead as they did up until now, happy days will come back to our shores again in 2018. Of course, relying on our domestic (real) economy to chug along as it did in 2003-2009 period means we will be back to 2007 levels of income some time around 2026. Mister Cowen can keep telling us that things have bottomed out and that all will be well once growth returns. Numbers are a bit more honest here.

What else did the QNA release give us that CSO omitted in its release?

Let's take a look at quarterly frequency:
Notice how both GDP and GNP are running close to (but below) 4-quarter moving averages? This is the third time it is happening in the current crisis and every time it is followed by a renewed pull away from the MA line downward. GNP is seemingly poised to cross over in Q1 2010, posting a possible quarterly gain. Of course, this is just a momentum force, which has to be backed by fundamentals. And the fundamentals are still pretty nasty. But there isn't a hope of even a technical rebound indicated in the GDP line. So:

• Will we see a GDP/GNP gap contracting somewhat in Q1 2010 with GDP starting to show much more weakness than GNP?
• Will GNP loose technical momentum building up and renew its downward slide?

Only time will tell, but, here is an interesting snapshot. Remember the latest QNHS? Q4 2009 marked the return of Construction sector to the leading role in driving unemployment higher. This is collaborated by the following figure:
Activity in construction and building sector shows absolutely no willingness to move above the moving average line. If anything, it is still contracting at a massively rapid rate.

Lastly, let me show you an interesting chart on annual rates of change in the GDP/GNP series:
Notice that in contrast with levels in overall activity (the first chart above), growth rates actually peaked in two different years, with 2007 decline in the growth rate of GNP clearly providing a warning signal for the Government that things might be getting slightly unsteady. Coupled with what was going on at the time in the financial markets (remember, the crisis in financial markets started actually in July 2007), that was a warning shot. I recall interpreting it this way in a couple of my columns - back in Business & Finance and in the Sunday Tribune.

I will cover trade figures contained in QNA release in the later post dealing with overall trade issues, so do stay tuned.

Economics 23/03/2010: Re-shuffling yields no trump cards

Let us first outline the conditions under which today's reshuffle took place:

• Earlier today Friends First Quarterly Economic Outlook predicted that after falling 50% since 2007, house prices will decline by 10% more this year. So the total drop through the cycle expected by Friends First is around 55%.
  

If house prices grow at 3% on average per annum, it will take us until 2038 before we recover the nominal losses in the property prices. If we are to assume that the spread between asking price premium paid in 2007 and asking price discount available today is 7.5% (+/-5%), to will take us until 2044 to regain the peak prices levels in nominal terms.

If property prices grow at 1.5% in real terms per annum (comparable to what has been happening in the better performing developed markets around the world since the 1960s), we will be able to restore 2007 levels of real housing wealth only in 2078, using the +/-5% discount/premium spread, or 2064 if we just take asking prices.

The previous Cabinet, absent three exceptions, has presided over this boom and the bust. The re-shuffled one did as well. Is this a dramatic departure from the policies of the old?

• Second, also today, a report from PwC has forecast that the Irish economy will shrink by 1.3% this year, before returning to growth of around 1.8% in 2011. This means that peak to trough PWC expects economy to contract 12% in terms of GDP, and approximately 16.3% in terms of GNP. PWC forecasts that economy will return to growth of around 1.8% in 2011.
  

Assuming this will be the 'new normal' on average, it will take Ireland Inc until 2019 to regain the nominal levels of GDP we enjoyed at the peak of the bubble and until 2021 to do so in terms of domestic economy income.

I am not going to outline the rest of the bleak conditions that form the backdrop to today's cabinet reshuffle, but it was clear from the beginning that a significant change in the Cabinet was required if the country were to have any hope of change in policies.

Which brings us to the new Cabinet formation:

Below, I will marks Taoiseach's decision out of 5 points maximum possible corresponding to 'Excellent' with 0 corresponding to 'Extremely Poor'. These scores do not attempt to rate individual Ministers past performance, but rather the decision made by Taoiseach in making new appointments.

• Mary Coughlan - Tánaiste, Minister for Education and Science – No comment – the title says everything… 0/5
• Brian Lenihan - Minister for Finance – the best we can do in this Cabinet… 5/5
• Mary Harney - Minister for Health – the only person willing to take the poisoned chalice and run with it for 6 years… 5/5
• Noel Dempsey - Minister for Transport – a safer bet, despite a number of high profile errors (T2 contract to DAA, etc) and insistence on a number of White Elephants, e.g. Metro North – 3/5
• Dermot Ahern - Minister for Justice, Equality and Law Reform – a better candidate for an economics post, but a good call for his current post as well. Ahearn deserved a promotion by virtue of being a more promising senior and experienced figure for key post and in this environment. Economics posts are the key ones – 3/5
• Micheál Martin - Minister for Foreign Affairs – best suited for his current role - 5/5
• Éamon Ó Cuív - Minister for Social and Family Affairs – think ‘experience’ (though he did run Gaeltacht Affairs - a largely welfare scheme) - 0/5
• Mary Hanafin - Minister for Arts, Sport and Tourism – Mary Hanafin deserved a much greater role in the Cabinet, with good potential to run an economics portfolio, her placement in Arts, Sports and Tourism is an opportunity foregone, 0/5
• John Gormley - Minister for Environment, Heritage and Local Government – this is a purely political balancing act, 2/5
• Eamon Ryan - Minister for Communications, Energy and Natural Resources – see John Gormley, 2/5
• Brendan Smith - Minister for Agriculture, Fisheries and Food - a very significant portfolio especially when one recognizes the role of food exports in total indigenous exports– see Eamon O Cuiv above, 0/5
• Batt O'Keeffe - Minister for Enterprise, Trade and Innovation – possibly an interesting move, risky, but… Batt O’Keeffe did some honest, if strangely inconsistent work in DofE. His record, ranging from brave and intriguing to unexplainable, should be interesting to watch at DETI. But is this a ‘steady, strong hand’ that one needs to move things forward in the second most important department in the country? I simply do not know. So: 3/5.

Average score: 28/60 or 47%. It won’t earn one a pass in a post graduate programme course.

Now to the second test – the rearranging of the chairs floating over the spot where Titanic sunk:

• The Department of Enterprise and Trade is now to take responsibility for Innovation. And lose responsibility for Employment. Given that DETE used to be one of the more competent of all departments in the past, this clearly suggests that the Government has no real policy platform for combating unemployment. Score on decision: 0/5.
• The Department of Education is to become the Department of Education and Skills. DofE has no capability or experience in dealing with the matters of skills. VAC schemes that it runs are shambolic at the very best and never were benchmarked or tested properly. To acquire expertise it would need FAS, plus some Forfas capabilities, plus access to multinational and domestic employers. DofE - focused on the needs of secondary education sector since its foundation - simply cannot be expected to deploy an enterprise-centred culture needed to build them. Score on decision: 1/5.
• The Department of Social and Family Affairs will become the Department of Social Protection - it will take responsibility for FÁS. Which now puts our Government into a position of formally admitting that FAS ‘training’ schemes are nothing more than social welfare designed to artificially reduce (temporarily) the Live Register counts. Furthermore, DofSocial Protection has neither expertise nor experience in dealing with training. This decision further fractured the employment training and skills policy. It also created an interesting conundrum. FAS has various embedded and affiliated bodies which include participation from private sector leadership. We are now likely to find ourselves in a comical scenario where private corporate leaders will be asked to provide public service to Social Welfare. Score on decision: 0/5.
• Equality is to go into the Department of Community and Gaeltacht affairs. This, of course, is a purely optical announcement with no real meaning, other than the potential for creation of new public sector employment - 0/5.
• Mr Cowen also announced the setting up of a Public Service Board, which aims to accelerate public service reform in consultation with the unions. Amazing: after a clear show of intransigence on reforms, the unions are now formally incorporated into the process of reforms. This legislatively establishes a one-sided form of sub-Social Partnership as an official part of the State – 0/5.
• Junior minister Dara Calleary will also be assigned to push through change in the public service. Junior ministry allocation to reforming something that accounts for over 40% of our economy? For over 1/3 of our entire Exchequer Budget? Combined with the PSBoard announcement, expect no reforms of any sort to come out within the life of this Government. 0/5 folks.

Total score on the Cabinet change and new ‘reforms’ of Departments: 29/90 or 32% - a Fail even in an undergraduate course.

Per RTE report: “Announcing his changes, the Taoiseach said he was not in favour of structural changes for their own sake and said the benefits the changes bring will outweigh the costs.” Read: no costings have been made, no benefits assessment was done.

Prepare yourselves to another Government that provides policies-based evidence instead of pursuing evidence-based policies.

Economics 21/03/2010: Reckless expectations, not competition

This is a lengthy post - to reflect the importance of the issue at hand. And it is based largely on data from Professor Brian Lucey, with my added analysis.

The proposition that this post is proving is the following one:

Far from being harmed by competition from foreign lenders, Irish banking sector has suffered from its own disease of reckless lending. In fact, competition in Irish banking remains remarkably close (although below) European average and is acting as a stabilizing force in the markets relative to other factors.


I always found the argument that ‘too much competition in banking was the driver of excessive lending’ to be an economically illiterate one. Even though this view has been professed by some of my most esteemed colleagues in economics.

In theory, competition acts to lower margins in the sector, and since it takes time to build up competitive pressure, the sectors that are facing competition are characterized by stable, established players. In other words, in most cases, sectors with a lot of competition are older, mature ones. This fact is even more pronounced if entry into the sector is associated with significant capital cost requirements. Banking – in particular run of the mill, non-innovative traditional type – is the case in point everywhere in the world.

As competition drives margins down, making quick buck becomes impossible. You can’t hope to write a few high margin, high risk loans and reap huge returns. So firms in highly competitive sectors compete against each other on the basis of longer term strategies that are more stable and prudent. Deploying virtually commoditized services or products to larger numbers of population. Reputation and ever-increasing efficiencies in operations become the driving factors of every surviving firm’s success. And these promote longer term stability of the sector.

Coase’s famous proposition about transaction costs provides a basis for such a corollary.

This means that in the case of Irish banking during the last decade, if competition was indeed driving down the margins in lending (as our stockbrokers, the Government and policy analysts ardently argue today), then the following should have happened.

1. Banks should have become more prudent over time in lending and risk pricing,
2. There should have been broader diversification of the banks lending portfolia, with the bulk of new loans concentrating in the areas relating directly to depositor base – corporate and household lending, and a hefty fringe of higher-margin inter-mediation lending to financial institutions, and
3. Banks would be seeking to ‘bundle’ more services to differentiate from competitors and enhance margins.
   

In Ireland, of course, during the alleged period of ‘harmful competition’ exactly the opposite took place. Let me use Prof Brian Lucey’s data (with added analysis from myself) to show you the facts.

Firstly, Irish banks became less prudent in lending – as exemplified by falling loans approvals criteria, and by rising LTVs:

1. Lending to private sector as % of GDP was ca 50% in 1995, reaching 100% in 1998 and rising to 300% in 2009
2. Vast increases in lending to developers: in 1997 there were €10bn lent out to developers against €20bn in mortgages; in 2008 these figures were €110bn and €140bn respectively
3. Over the time when lending to private sector rose 600%, mortgages lending rose 550%, our GDP rose by 75%
   

Secondly, banks reduced their assets and liabilities diversification (charts 1-3 below) setting themselves up for a massive rise in asymmetric risk exposures.

On the funding side, out went customers deposits, in came banks deposits, foreign deposits and bonds and Irish bonds.
Capital ratios fell out of the way.

And so there has been a change in the world of Irish banking that no other competitive and mature sector of any economy has ever seen. Why? Was it because foreign banks started pushing the timid boys of BofI and AIB and Anglo and INBS out into reckless competitive lending?

You’ve gotta be mad to believe this sop. In reality, the Irish banks’ assets tell the story.

Business loans collapsed, personal loans (the stuff that allegedly, according to the likes of the Irish Times have fuelled our cars and clothing shopping binge during the Celtic Tiger years) actually declined in importance as well. Financial intermediation – the higher margin, higher risk thingy that so severely impacted the US banks – was down as well. No, competition was not driving Irish banks into the hands of higher margin lending. It was driving them into the hands of our property developers. We didn’t have a derivatives and speculative financial investment crisis here – the one that was allegedly caused by the foreign banks coming in and forcing our good boys to cut margins on run-of-the-mill ordinary lending. No, we had an old fashioned disaster of construction and property lending.

And this lending could not have been driven by foreign banks. It came from the total expansion of credit in the economy, presided over by our Central Bank and Financial Regulator, our Government and ECB.

Just how dramatic this change was? Take a look at the ratio of private sector credit to national income in the chart below.
Even a child could have seen the bust coming. The reason that our Financial Regulator and Central Bank failed to see this, despite publishing all this data in the first place, is that they were simply not looking. The former probably obsessed with the pension perks, the latter – well, may be because all the fine art in the Central Bank’s own collection was just too much of a distraction. Who knows? But judging by the above chart lack of significant correction during the crisis – we know who will pay for this in the end. Us, the taxpayers.
As chart above shows, the fundamentals for the boom – in lending and in construction – were never there, folks. And the banks missed that completely. As did our regulators and our policymakers. Brian Lucey of TCD School of Business provides evidence on what was really going on in the Irish banks (again, note that some of the analysis below is mine).
Chart above, based on the Central Bank Credit Survey, basically shows the impact three major forces: expectations of increased competition by the banks, improved banks outlook on the Irish economy three months ahead, and LTVs expectations had in Irish banks willingness to increase lending. Scores above 3 represent tightening of credit conditions (as in banks expecting to cut lending to households), while scores below 3 show forces driving looser credit to households.

If the proposition that foreign banks competition pressures drove Irish banks into looser credit supply were to be correct, one would expect the blue line above to reach far deeper into ‘below 3’ scores than the other two lines. Alas, it did not dip. In fact, competition from other banks was recognized by Irish Bankers themselves to be the least improtant factor contributing to credit supply expansion. Instead, their over-optimism about economic prospects (red line) and their willingess to give away cash at massively inlfated LTVs (the orange line – also a proxy for Bankers’ optimism regarding future direction of house prices) were the two main drivers of credit boom.

Where’s the evidence on ‘harmful competition’ that so many Central Bank leaders, the stockbrokers and Government spokespersons have decried in recent past?

The delirium of our bankers was actually so out of any proportion that, as the surveys data shows, even amidst the implosion of the housing markets since early 2008 they were still saying “hang on....we expect that changes in LTV and economic prosoects will cause us to loosen in the next 3 months". In other words, they were chasing the deflating bubble, not the imaginary foreign banks competitiors.

Let’s take another look at Brian Lucey’s data. Take the scores for Ireland in the above surveys and take their ratios to the Euro area average scores. If the ratio is in excess of 1, then the said factor has contributed to greater tightening in credit supply in Ireland than in the Euro area. If it is less than 1, then the said factor has contributed more to loosening in lending in Ireland than in the Euro area.
So, really, folks, competition in Ireland was actually more of a stabilizing force, than de-stabilizing one. LTV’s optimism and lack of realism in economic forecasts were the two main driving forces of the boom.

Lastly, ECB Herfindahl Index (ratio of Ireland to “big5” EU states) provides exactly the same conclusions:
Again, what above shows is that on virtually every occasion, Irish reading for Herfindahl Index (measuring degree of concentration in banking sector) is in excess of the average Index reading for top 5 EU countries. In other words, there was no such thing as ‘too much competition’ going on in Irish banking sector. If anything, there was somwhat too little of it, compared to Germany, France, Italy, UK and the Netherlands.

And now, for the test of all of this. The chart below regresses each survey factor on the private sector credit index. The negatively sloped line – for LTV and economic prospect factors combined - shows that when this factor scoring in the survey increased, lending became tighter. Positively sloped line – for competition – shows that when competition pressures rose (factor reading declined), lending actually got tighter. And the statistical significance of the LTV and expectations factors is more than double that of competition...
Let’s just stop talking nonesense about too much competition in Irish banking sector drove unsustainable lending. More likely – an anticiaption by our bankers that no matter what they do, they will never be allowed to fail by the state, plus an absolutely rediculous expectations about opur economy drove our banks to the brink.

Economics 18/03/2010: Services Inflation in Ireland

CSO released an interesting set of new stats on price inflation in select services. Per experimental Services Producer Price Index (SPPI) average prices charged by domestic service producers to other businesses in Quarter 4 2009, were on average 4.1% lower in the year when compared with the same period last year.

The most notable changes in the year were:

• Architecture, Engineering and Technical Testing (-9.7%),
  
• Computer Programming and Consultancy (-8.5%),
• Advertising, Media Representation and Market Research (-7.2%),
  
• Freight and Removal by Road (-5.2%) and Air Transport (+6.3%).
  

Services Prices increased by 0.4% in the quarter. This compares to a decrease of 2.3% recorded in Q3 2009.

The most significant quarterly price decreases were in

• Freight and Removal by Road (-2.2%),
  
• Postal and Courier (-1.4%) and
  
• Sea and Coastal Transport (-1.4%).
  

There was an increase of 4.8% in Air Transport.

Now, what CSO report did not show is the following. While deflation in higher value added, human capital-intensive services was rather significant, mid-range value-added services saw much more moderate deflation, with low value added labour-intensive sectors such as security services holding up almost unchanged over time. Chart below illustrates:
For all the talk about improved competitiveness, transport-related services costs are still on the upward trend:
And this is before Carbon Taxes kicked in.

Another interesting point to be made here is that the first chart above appears to suggest that deflation is almost not happening at the level of sectors that are labour intensive - industries most impacted by the minimum wage. In more wage-flexible sectors, where human capital drives value added to much higher levels, inflation is running negative. This has two implications going forward, should this trend persist:

1. Despite all the talk about the 'poor' bearing the brunt of the crisis, at least as far as prices charged for services indicate so far, there is most likely stronger deflation of wages at the higher end of wages distribution;
2. While competitiveness of our traded and higher value added services is increasing, competitiveness of our domestic services (anchored in higher labour intensities) is not improving significantly.
   

Economics 18/03/2010: A new warning to Ireland

Ireland was put on notice in the EU Commission assessment of fiscal positions going forward. per FT report today: European Commission warned eight countries, including Germany, France, Italy and Spain, Austria, Belgium, Ireland and the Netherlands that their forecasts for fiscal deficits reduction and growth for the next 4 years are basically failing to meet reasonable tests of robustness and that they need to identify exact measures they will take to meet their medium-term deficit reduction targets of 3 per cent or less of gross domestic product.

This is a second round of warnings covering Ireland's budgetary plans after earlier this month the ECB has qualified its assessment of Euro area fiscal consolidation measures with a statement, in the case of Ireland, referring to the lack of clear evidence on the ways in which the target will be achieved (see ECB Monthly Bulletin, 03/2010 page 85).

The warnings - usually a saber-rattler, and nothing more - but this time around it is a serious note. The reason is simple. It now appears that Germany is set against a direct bailout for Greece, pushing instead for joint IMF/Euro area action backed primarily by IMF. Here is the background on this:

Bloomberg reports (here) that Michael Meister, the CDU’s finance spokesman, said: “We have to think about who has the instruments to push for Greece to restore its capital-markets access... Nobody apart from the IMF has these instruments,” and that attempting a Greek rescue without the IMF “would be a very daring experiment.”

Angela Merkel told the German parliament yesterday: “The problem has to be solved from the Greek side and everything that is being considered has to be oriented in that direction.”

This clearly implies that fiscal deficits corrections will have to be pursued by countries in the environment where the markets cannot price in collective risk averaging within the Euro area, which in effect means that spreads between German and PIIGS bonds yields will have to rise and stay elevated through 2014. And this, in turn, means Ireland is now exposed to a potential sever credit crunch on the Government side.

And there is an even greater threat for Ireland, as Irish Exchequer is much more dependent on the good will of German banks than any other Exchequer in the PIIGS club (see chart below, courtesy of http://spaineconomy.blogspot.com/):
Frightening, especially since the chart is expressed in Euros, which of course puts us well ahead in proportional terms of Spain, not to mention Portugal and Greece, for all countries, except Switzerland.

Economics 17/03/2010: Nama Estimation Procedures

Yesterday I finally got a few minutes to read through the latest Government documentation on Nama - "Determination of Long-Term Economic Value of Property and Bank Assets" regulations SINo88 of 2010 from March 5 (link here). This delightfully thin document is a treat for anyone who cares to study just how inept our authorities can be when it comes to measuring and assessing/pricing risk.

Timing

Paragraph 2 page 2 defined 'relevant period' - used in assessing long-term economic value - as 'the period that began on 1 January 1985 and ended on 31 December 2005'. Per para 5.ii page 3, this period will be used to estimate reference prices for land based on land hedonic (econometric) links to demographic variables (5.b.i), interest rates (5.b.ii) and GDP (5.b.iii).

The problem here is that there is no clear identification as to which time horizon (the full 21 years worth or some sub-set thereof) the Government will use. And this is crucial, as this period largely covers steadily rising market with almost no corrections. Which means that should Nama use dynamic trend for estimating the land prices, it would be rather accurate within the sample, but will be absolutely ad hoc outside the sample (per Lucas critique).

Of course, Nama won't take dynamic pricing - and as is clear from 5.(1).(a).(i) and (ii) it is going to take 'prices' and 'yields' - i.e. point estimates. Which most likely means some sort of an average. It is important, therefore, to have an exact idea as to within what sub-period of 1985-2005 is this average going to be taken. The note does not identify this exactly, leaving the door open for Nama to deal with the data as it sees appropriate.

Discount factors

There is an added complication to the entire valuations scheme. SSNo88 states in 5.(1).(a) that a discount (adjustment) factor for land located within the State will be based on a difference in price of land on valuation date (nearly absolutely unknown to Nama) and the Long Term (economic) Value (LTEV) price (also unknown to Nama). And this means that Nama will start its valuations process by applying an unknown discount factor to a risky asset it is buying. No data listed within SSNo88 as the basis for valuations allows Nama to escape this grim reality.

Discount Rates

There are other fundamental errors built into valuations process. For example, NAMA discount rates - equivalent to interest rates - on bank assets are (as listed in 2.(2).(a)-(b) on page 2: 4.54% for 3-year rate, 5.57% for 5-year rate, and 6.16% for 8-year rate. This presents a little bit of a conundrum. Firstly, are these rates annualized compounded or simple? Second, and even more important - why are these rates chosen for these maturities? What yield curve has been used to impute these? No clarity on this whatsoever.

ECB gives only two types of average retail rates for non-financial corporations loans: as of January 2010 (the latest), we have existent loans with rate fix up to 1 year are priced at 2.96% which, factoring in Government's 1.7% risk premium margin implies a rate of 4.66%, not 4.54%. Off the starting line, there is a built in subsidy from Nama.

And this subsidy is greater than 12bps spread between the above two rates. How I know this? Well, think - can assets we are buying into Nama attract any loans in the private sector? At any valuations? No. So what justifies that 1.7% risk premium the Government applies (per 2.(2).(a)-(c)) to all loans it will be buying? And why is the risk premium independent of maturity period? Surely it should be rising with maturity?

Let's take a look at what we have from the ECB: non-financial corporate overdraft rate as of January 2010 averaged in Ireland at 5.74%. Suppose this was the basis for our Nama valuations (I still think this is too low of a rate given the assets quality and given the fact that ECB reports 'offer' rates by the banks, not the actual rates on which loans were issued, but what the hell, let's use this as a base assumption).

With Government risk premium, this should imply a 3-year discount rate of 7.44% (still shy of corporate junk bonds, but much better than 4.54% built into Nama). This rate (per 7.(a)) will cover land-backed loans where land value has fallen just 10% below its LTEV - the high quality loans in Nama books. Now, using SSNo88-implied yield curve, 5-year discount rate consistent with our assumed base rate should be 2.08% and for 8-year rate, the risk margin should be 1.9%.

This means that if Nama were to use the riskiest loans rates we have - those for overdrafts by non-financial corporate sector, and use upward sloping risk margins (to reflect the fact that the longer the duration of the rate, the lower is the quality of assets to which it applies - per SSNo88 page 5 own admission), the rates of interest imputed on Nama assets should be:

• 3-year money - at 7.44%, not Nama-assumed 4.54% (a loss to the taxpayer or a subsidy to developers and banks of 2.9% per annum);
• 5-year money - at 9.13%, not Nama-assumed 5.57% (a loss to the taxpayer or a subsidy to developers and banks of 3.56% per annum); and
• 8-year money - at 9.67%, not Nama-assumed 6.16% (a loss to the taxpayer or a subsidy to developers and banks of 3.51% per annum).

Let me give you a look at the Nama interest rate pricing generosity from another angle. Irish Exchequer is currently borrowing at 5% interest rate in the markets. This, presumably does not include Mr Lenihan's 1.7% risk margin. Which means that if Nama was buying loans from borrowers who are as credit-worthy as the Irish Exchequer, it should be applying a rate of 6.7% to these loans. My estimate of 7.44% is much closer to that than SSNo88 statutory fixed rate of 4.54%.

Proposition: under Nama, effective interest rate subsidies for defaulting loans (accruing to banks and developers) will range between 2.9% and 3.56% per annum.

Proof: see two alternative arguments above.

Estimation process

Another issue, related to interest rates arises when the SSNo88 outlines 3 sets of variables Nama will use to impute LTEV based on 'correlation' (whatever this means in econometric terms, I have no idea): 'between land prices and interest rates in the State' (5.(1).(b).(ii)). Can someone explain to me which interest rates Nama has in mind? Central Bank rates? Retail rates? Retail rates for non-financial corporations loans?

The same applies to paragraph (5.(1).(c)).

Valuations timing

The document SSNo88 was published in March 2010. Nama will not begin valuations before April and will not finish these before the end of 2010 (optimistic projections). So why are all valuations being made by Nama will take into account only market values of land prior to January 10, 2010? Surely, falling markets mean - and consensus forecast expects - at least 5%+ decline in house prices (what can one say about land!) over 2010. Is Nama going to ignore this reality and price the assets in buys in, say, November 2010 at prices valuations for January 2010?

Let me explain. In a year when I bought my house, within 11 months of my purchase, home prices fell roughly speaking 3%. Do I get to go to my bank and tell them - 'Folks, shave off 3% from my total original mortgage as Nama is doing for you?'

5% is a non-trivial number, adding up, over the loan book Nama id about to take up roughly €3.9 billion overvaluation, spread over 15 years with interest and market discounts accruing to it.

Use of GDP

SSNo88 applies to valuations of land and real estate assets. These are non-exportable. Why is then the Government planning to use the rates of growth in GDP, not GNP? Does our booming (1985-2005) pharma sector has anything to do with the fundamentals on which land prices are set? Using GDP for the estimation process instead of GNP introduces a distortion of between 12% and 18% depending on the range of years used. This distortion risks further overvaluing the LTEV for land.

Building in dreamy planning

Paragraph 5.1.d.ii states that Nama will use "existing and future transport planning and the associated supply and demand projections for land use" in its valuations of LTEV. What does this mean? Will Nama use full extent of NDP plans? Including the frozen and indefinitely postponed plans? There is significant divergence between what is planned and what is delivered. And in the next 10 or so years, this divergence will be in the direction of planned transport investment being well in excess of real investment. If Nama were to use the former as a basis for estimates, then there will be land with LTEV in excess of realizable value because its estimated LTEV will be based on excessively optimistic plans for transport investment.

At any rate - the current phrasing of the SSNo88 does not provide for a rigorous definition of what planned infrastructure will Nama actually factor in. This makes the LTEV estimation process outlined in LTEV completely undefinable under the current legislation.

Land based outside the State

The entire section 6 outlining the LTEV estimation process for land outside the State is simply a carbon copy of the valuation processes for LTEV within the State. This suggests that - given that assets being valued are different in nature (legal and economic), risk and geographies - the Minister has no idea how these different risks should be reflected in the estimation process.

The section does not even mention exchange rate risks or derivatives on Forex exposure attached to loans. There is no clear understanding as to what interest rates should apply and how to deal with the carry trades.

Operational costs

Section 8 of the note states that the assumed 'due diligence costs, incurred or likely to be incurred by Nama over its lifetime' is 0.25%. This is simply unrealistic. Industry average operating cost on performing loans - across all subheads - is equal to about 0.75-1% in times when operating conditions are deemed to be normal. As of the end of February 2010, Nama, reportedly already has blown through its entire 2010 legal budget. How can 25bps cover its due diligence cost over life time?


In short, SSNo88 is yet another document that shows just how exposed Nama remains to shoddy planning and poor estimation procedures, courtesy of the DofF that simply cannot deliver realistic and transparent operational guidelines.

Economics 17/03/2010: Stuck in the Euroland

The silver lining to the ongoing PIIGS crisis in the Euroland is that finally, courtesy of the severe pain inflicted by the bonds markets, Brussels (and more importantly the core nation states) is forced to face the music of its own making.

I wrote for years about the sick nature of the European economy - at the aggregate levels and individual countries cases. Today's FT Alphaville article by Lombard Street Research’s Charles Dumas (here) offers another great x-ray of the issue:

Dumas' chart clearly shows just how sick the core Euro area economies are and how structural this sickness is. With exception of the bubble-driven catch-up kids, like Spain, the Euro area has manged to miss the growth boat since the beginning of the last expansion cycle.

"The chart above shows real GDP growth from the end of the last recession… Germany is placed evenly between the Sick Man of Europe, Italy (with no growth at all – the very fact of EMU membership has been enough to crush Italy), and the Sick man of the World, Japan (which at least managed nearly 1% annual growth). Germany’s pathetic advance over eight years was 3½%, less than ½% a year, and one third of the growth of Britain and France…" But France, and the UK, have managed roughly 0.975% annualized growth over the same time. Comparing this to the US at 1.27% puts the picture in clearer perspective.

The problem, of course, is much greater. I wrote before that the real global divergence - over the last 10 years - has been happening not via the emerging economies decoupling from the US, but via Europe's decoupling from the rest of the world. The chart above clearly shows that this significant in economic terms (as the gap between European 'social' economies wealth and income and the US/UK is still growing). But the chart also shows that Europe is also having a much more pronounced recession than the US.

Europe's failure to keep up with the US during the last cycle is made even more spectacular by the political realities of the block. Unlike any other developed country or block, EU has manged to produce numerous centralized plans for growth. Since the late 1990s, aping Nikita Khruschev's 'We will bury you!' address to the US, Brussels has managed to publish a number of lofty programmes - all explicitly aimed at overtaking the US in economic performance. All promised some new 'alternative' way to growth nirvana: Lisbon Agenda was followed by Social Economy, which was displaced by the Knowledge Economy. The latest installment - this year's Agenda 2020 is a mash of all three - the strategies that failed individually are now being mixed up in a noxious cocktail of economic policy confusion, apathy and sloganeering.

But numbers do not lie. The real source of Euro area's crisis is a deeply rooted structural collapse of growth. No amount of waterboarding of the real economy with cheap ECB cash, state bailouts and public deficits financing will get us out of this corner. Tax cuts paid for through fiscal spending reductions could have helped in the long run by deleveraging Europe's economy out of the state control bubble. But this opportunity is now firmly wasted through unprecedented amounts of deficit financing deployed in 2009-2010.

Never mind Greece and the rest of PIIGS, EU has no growth engine to get ourselves out of the Japan-styled (or shall we call it Italy-styled) long term stagnation.

Economics 16/03/2010: What's wrong with 'spend now' economic development

Please, tell me if I have woken up on some planet called 'Wealth, Prosperity and Boom Times'? The last couple of weeks have positively turned into some sort of a macabre Hollywood serial where by every other day some new 'Group', 'Taskforce' or a plain 'White Paper' or 'Strategy' comes out with a cheerful idea of spending more money we do not have on thing we do not really need. All of this is cloaked in a veil of economic 'programmes' and 'targets' that inevitably promise thousands/tens-of-thousands/hundreds-of-thousands of new and ever-better-paying jobs sometime in the next 10 years.

I stretch my arms, rub my eyes and slowly rise to the dawn of the 'new prosperity'. For prosperity, with a massive capital 'P' is what it will take to actually get a single job out of the Innovation Task Force, the TASC L28, the Farmleigh Report... and now, the ideas that some of our University heads have.

So let me briefly outline another Grand Project 'Irish Awakening' installment. Albeit more modest (it would only cost a handful of million to set up and as much to operate annually), the idea of setting up a separate Minister (with her own Department) for the 3rd level education, floated out by DCU president Prof Ferdinand von Prondzynski in the end bears about the same relation to addressing the real problems of Ireland Inc as Eskimos' annual seals hunt does to flyfishing in New Zealand.

Prof Prondzynski is right in identifying continued underfunding of our universities as a major problem. I agree with him here, although we disagree (and only partially) on what this funding should deliver and also on where it should come from.

But setting aside these differences, how can such an experienced and accomplished university head confuse the appointment of a high office of a Minister with a functional policymaking and regulatory/funding outputs? All that a separate Ministry would do is suck massive amounts of funding to finance pay and perks of its own employees, sprinkled with rows upon rows of addictive junkets for the Minister and her entourage.

Take current 50 bureaucrats administering Universities funding. Put them into a separate Department, appoint a senior minister for that and you have 80-100 headcount of new paper pushers. The cost? Oh, at an average wage in the public sector, plus trimmings, plus employment-associated costs, junkets and so forth - conservatively starting at €8 million per annum. Oops, there goes a large chunk of funding for some 3rd level institution.

More fundamentally, to say that adding a new layer - whether independent or not - of bureaucrats to the already cumbersome, nearly Byzantine system of controls, budgetary appropriations and regulatory constraints will make Universities funding any more visible or transparent is a strange sort of logic.

The problems with our Universities funding can be ranked, in terms of their gravity, and thus priority, as follows:

1. Lack of direct relation between university performance (in terms of quality of its academic research and teaching) and funding (disconnect between end-user / customer - corporate and students). This can only be resolved through introducing fees-based competition and through more direct corporate funding of research (not as a pure substitute for public funding, but as enhanced addition to it). Setting a Ministerial office for 3rd level institutions will do nothing here;
2. Lack of direct managerial capability over staffing (the problems of centralized wage setting and tenure). Again, this cannot be addressed through a Ministerial remit, but will have to involve decentralization of management and finances to give Universities more autonomy;
3. Lack of private sector funding for R&D - a problem that is extremely acute and cannot be resolved through any Ministerial diktat. Only significant improvement in research system transparency, allowing the best universities and researchers (including those from DCU, where Prof Prondzynski should be credited with achieving serious and positive transformation on research front) to directly and openly compete for research funding can do the job. If anything, Universities research funding activities must be also seen as a potential avenue for exports from Ireland of knowledge economics and in this, Universities can and should be assisted by Enterprise Ireland and other export-development agencies. Again, however, a separate Minister for 3rd level education will do absolutely nothing here.
4. Difficulty of accessing new R&D funding streams (e.g EU funds). Again, to address this problem Universities need to become more competitive and more aggressive in cutting through the fog of 'collaborative research' simulacra. Only truly productive collaborative research should be pursued and the idea that collaboration is of value on its own - as currently pursued by our funding authorities - must be dealt away with. This cannot be done through more centralization of decision making - as consistent with single Ministerial authority.

So none of the real problems and opportunities faced by our Universities require a new Ministerial post. And, of course, our budgetary constraints hardly permit such a lavish addition to the ranks of policy boffins.


And thus, returning back to the general theme of economic policy by 'borrow more now to get hundreds of thousands of jobs tomorrow', let me tell you an ancient fable that aptly describes what I think of all the proposals for setting spending-based targets for future growth. Back in the Middle Ages - around 13th century - there was a great character employed by Sultan. His name was Hoca Nasreddin. One day he came to his friends to tell them that he was just employed by Sultan to teach Sultan's pet donkey how to read. His friends were alarmed, as none of them believed this can be done. They were concerned that Sultan, upon learning of Nasreddin's inevitable failure to perform the task will have Nasreddin's head cut off. "Do not worry, my friends," replied Nasreddin. "In ten years, when contract is up, either Sultan will be dead, the donkey will be dead or I will be dead."

Ditto for all the promised hundreds of thousands of jobs by 2020 - how many heads of authorities or political leaders responsible for producing these targets today are likely to be there in 2020 to account for these plans? Of course, in the mean time, they all want us to pay for these now. Spot the fools in this scheme?

Economics 15/03/2010: The failure of the state is a failure of society

Here is an unedited version of my article in the current issue (March-April 2010) of Village magazine.

Pull Quote: “Replacement of foreign élites with domestic elites was the main objective of Ireland’s change.”

“It only stands to reason that where there's sacrifice, there's someone collecting the sacrificial offerings…The man who speaks to you of sacrifice is speaking of slaves and masters, and intends to be the master”. Ayn Rand.

“”Sacrifices needed for recovery”, says Cowen.” Irish Times headline 5^th Feb 2010


The fundamental problem with Irish politics is not our much-decried proportional representation electoral system or the absurd subatomic fragmentation of politics into parish-pump power brokerages. The most rotten aspect of our political environment is the culture of clientelism that underlies the foundation of society. To understand this, take a quick detour back in time. The American Revolution and the Irish struggle for self-determination had a common adversary – the British Empire. But this is where the similarities end.

American Model

The US was founded on the core idea that without British rule, the ordinary people could improve their own governance. The Declaration of Independence is rooted in the Enlightenment, which informs its outline of where the Brits have gone wrong: not so much in underwriting the entitlements of the people, but in directing the policies of the land. Although most scholars tend to focus on the opening lines of the Declaration, denigrating the remainder as a laundry list of British offences, in reality both parts of the Declaration are pivotal to the balance of power between the individual and the state. The Declaration clearly posits the state as the tool for implementation of the new order. Not as the order itself. In Ayn Rand’s terms, American statehood is not about sacrifice of an individual for the sake of the collective, but about removing the state from the position of delineating slaves from masters. The US was formed not as a sacrifice of the few for the sake of the many, but as a project for improvement of opportunities for all.

Irish Model

The Irish state was born out of a more limiting premise - that, without British rule, native elites can be just as effective (or ineffective). Replacement of foreign élites with domestic ones was the main objective of Ireland’s change. In religion, administration, property rights, culture, society and economics, the Irish Revolutionary movement, justifiable as it may have been, accomplished only the equivalent of a coup d’état, leaving ordinary people in semi-servitude to the new, this time around native, political and administrative master-class.

Out of the necessity to bow to modernity, we added a second tier to our traditional economic structure. Ireland Inc - multinationals and exporters responding to global markets and incentives – is now juxtaposed against the clientelist domestic sector run on the back of parochial interests. Ireland’s gross public expenditure in 2009 reached €76.2 billion or 57.3% of our national output. Including our semi-states and state-licensed activities, over 70 cents of each Euro circulating within Ireland is now state-controlled. Irish domestic economy in thus equivalent to a teenager with a job at a fast-food joint who lives with his parents. Over 65% of the population is in some sort of direct dependency on the state – either as its employees or as the recipients of its subsidies. This in itself accounts for the weddedness of so much of the population to the strong state.

Constraining the State

Last month, MIT Professor Daron Acemoglu, published a paper entitled, Institutions, Factor Prices and Taxation: Virtues of Strong States? As Acemoglu shows, strong states conduce to redistribution of resources and thus, to an even greater capture of the state powers. The fraught UK experience implies that efficient, functional states require more external checks and balances, not the vesting of more autonomy and power in the state institutions. This flies in the face of the Irish political ethos, which sees the state as a combination of a powerful autonomous bureaucracy and the clientelist political establishment. But it also puts into a historic perspective the serial failures of Irish society to revolutionise our state structures.

Ireland never had England’s Cromwellian experience of the renewal of élites. Nor did we have a full-blown industrial revolution to deny the idea of clan-based power. We missed out on the Thatcherite revolt against the ideological elevation of society over individual rights. Once again, Ayn Rand captures the point: “Individual rights are not subject to a public vote; a majority has no right to vote away the rights of a minority; the political function of rights is precisely to protect minorities from oppression by majorities (and the smallest minority on earth is the individual)”. Whatever position one might occupy in terms of party politics in Ireland, we must surely agree that any society based on the insistence of SIPTU-ICTU-CPSU that the Social Partnership overrides the individual, is simply incompatible with liberal democracy protective of individual rights.

Liberalism Vs. Statism

Rand’s scepticism about the compatibility of state interests and universal personal liberty separates the liberalism (that Ireland’s national institutions never managed to learn) from neoliberalism (to which we have developed a cross-party devotion). Stephanie Lee Mudge of the European University Institute defines neo-liberalist politics as “struggles over political authority that are bounded by a particularly market-centric set of ideas about the state’s responsibilities… and the state’s central constituencies (business, finance and middle class professionals)”. Of course neoliberalism is nothing more than a conservative, status quo preserving ideology - it's struggles against authority are a form of resistance against a change of elite, not in favor of change. Unlike neoliberalism, liberal principles do not identify specific interest groups as the pillars of society. Liberty and reliance on central constituencies – whatever the latter might be – can coexist in a democratic society if and only if society has an advanced system of political, administrative, judicial and social checks and balances.

In Ireland, no such checks and balances exist. NAMA and the rescue of bank shareholders and bondholders at the expense of taxpayers could never have happened in societies with modern state infrastructures. It did not happen in the US, where TARP was instantaneously altered to a much more robustly enforceable direct lending and equity takeover. It did not happen in the UK, which adopted a similar approach. It did happen in Ireland and other parts of Europe. Why? In Europe, the judiciary is a function of the political establishment that appoints it, the state is subjugated to the interests of the permanent civil service, and the political realm is dominated by the cartel of vested interest groups i.e. the Social Partners. In Europe, neoliberalism today is an a-ideological deus ex machina for continued propagation of the élitist State in exactly the same way as fascism and socialism were engines of elitism in their turn.

Ironically for their promoters, minorities, the poor and the downtrodden would do much better in a society based on liberal (or in American terminology libertarian) ideals than in their gold-gilded cage of Social Partnership. As Rand noted, libertarians believe that all minorities - rich and poor alike - are the same. To our political élites on the other hand, minorities are divided into Leninesque ‘useful idiots’ (the Social and Environmental Pillars) whose consent to the status quo can be bought for tuppence worth of State subsidies; and ‘powerful conservators’ (Big Business and the Unions) who can provide the power and money necessary for perpetuation of this status quo.

To An Ever Braver World

The maze of interchanges in a small country between sectoral vested interests – political and executive, social, environmental and economic – is informing our ideological and electoral positions. The state is seen as an (at least occasionally) benevolent defender of the interest to which one is aligned. The stronger state, therefore, is just that, a stronger defender. From the intellectual laziness of our academics, to the nearly unadulterated parochialism of our regulatory and legislative interests, to our clan-based politics, the ills of our society are traceable to the historically conditioned inability of Irish society to accept the basic tenet of liberty. We have never learnt that any vested interest, no matter how small, must be treated at a political level as a monopoly-seeking cartel. This, of course, coupled with the recognition that the state itself is a collection of those vested interests, means that the pursuit of liberty for all, requires a coherent limit on the State. The power and financial privileges that have accrued to nearly all of us, as vested interests, have prevented us seeing that.