Tuesday, 30 November 2010

Waiting for an explanation

What baffles me most about the Irish banking debacle is that I have not yet seen anyone offer an explicit explanation of why banks (plus buidling societies etc.) alone should be exempt from the insolvency laws that govern all other corporate entities?

It seems now to have been enshrined into the law of the land. Talk about moral hazard.

Monday, 29 November 2010

Breaking the piggy bank

So we will be spending another €12.5 billion of our National Pension Reserve Fund as part of the EU/IMF "Bail Out".
This seems to have raised some hackles, but I don't know why. Generally, in your personal finances as well as national one you would always tend to use the cheapest source of funds first.
How much does our NPRF stash cost us? Well, we could retire €18 billion of Irish 6 year government debt for more than 8% per annum. That alternative use makes this expensive money.
We are at the point where we need to do everything possible to stem the growth in our debt. Ideally, we should have been cutting our exposure to bank liabilities. But if we aren't then we have to accept our rainy day has arrived. Time to break the piggy banks.

Friday, 26 November 2010

Scary numbers - debt dynamics in Ireland

I thought I would review some of the debt dynamics for Ireland. It turns out that within a common currency area there is a twist on the normal dynamics that would apply.

Let's start with a little algebra. General government debt as a percentage of GNP will grow as interest accrues (r) and a the government run a deficit before interest (primary deficit) and it will be deflated by the rate of nominal growth in our income (GNP)

Using some mathematical manipulation we can see that the debt to GNP ratio will only stabilise or fall if the government runs a primary balance which is larger than the sum of the difference between Irish real growth and Euro real interest rate, plus the difference between Irish inflation and Euro inflation, all scaled by the ratio of debt to GNP.

When this is normally done for an economy the inflation terms simply cancel one another out - the inflation rate at which the economy grows is the same as the ex post inflation premium paid through interest. For Ireland and indeed any Eurozone country, this is no longer the case. What this is saying is that we are borrowing on terms that reward lenders with an inflation risk premium that relates to the currency of issue, the Euro. However, Ireland will need to service the nominal repayments out of a tax base that will rise only with domestic inflation. A nasty twist for Ireland at this juncture, when one might anticipate a significant ongoing real exchange rate depreciation - in common English; falling Irish prices relative to Euro prices.

So from this relationship we can play with scenarios.

I plug in numbers that would represent a pessimistic scenario relative to official plans.
  • Very weak medium term growth of 1%
  • Real Euro interest rates of 3% (5% minus 2% Euro inflation)
  • Deflation in Ireland relative to the Eurozone (zero inflation here, 2% in Eurozone)
  • All multiplied up by 150% which represent our debt to GNP
Under such assumptions Ireland would need to run a primary balance of 6% of GNP or greater. Our tarting point is a deficit of about 10% of GNP. We would need a fiscal adjustment 16% of GNP or more to stabilise our debt. And the kick is that if we allow the debt to GNP ratio to rise further the surplus we need to run on our primary balance becomes larger - i.e with debt at 200% of GNP that 6% required primary surplus becomes an 8% primary surplus. Ouch.

I think the worry is that the more we deflate (Irish inflation lower than Euro inflation) the bigger the fiscal adjustment needed. And the bigger the fiscal adjustment the more deflation we bring. A viscious cycle that leads to national bankruptcy.

Let's not underestimate what the stakes are with the decisions we will be making over the next weeks.

Wednesday, 24 November 2010

Why did AIB retain its stock exchange listing?

It is a curiosity that AIB will retain its stock exchange listing for stock issued which accounts for one tenth of one percentage of the company's ownership. The obvious question is why??

Initially I thought it was to allow restructure and eventual sale of the company, without going through the hassle of nationalisation and a completely new IPO.

Then I read this:


Thursday, 7 October 2010: Following the Statement on Banking made by the Minister for Finance on 30 September 2010 there has been some uncertainty among market observers and participants about the intended treatment of subordinated debt in issue from Irish banks.

In order to clarify the position the Minister has advised that prospective resolution and reorganisation legislation, insofar as it affects subordinated debt in issue, will apply only to such debt in issue from institutions which are not listed on a recognised stock exchange, are in 100 per cent State control and cannot survive in the absence of total State support.

My bold.

Note that AIB isn't going to be delisted from a recognised stock exchange, nor pass into 100% state ownership.

Comfort for AIB subordinated bond holders then. Thanks for that Brian.

Yours sincerely,

Taxpayer Bled-Dry Esq.

Oh, forgot to add. Can anybody name a bank that is not listed on a recognised stock exchange, is 100% owned by the Irish government and cannot survive without State support?


Closed to new borrowing!!!!!

More tripe being spouted from government circles about why we need to stay committed to pouring more and more of taxpayers' money into Irish banks in order to prevent them going into insolvency and default on their liabilities.

The cry goes out "if there is a default on bank bondholders now, nobody will lend to us in the future".

OK, let's put aside the obvious point that nobody has been willing to lend to either Irish banks and now the Irish government at an affordable rate of interest for some time now and think about that alarmist statement. It is nonsense of course.

The fact is that default on bondholders today will not in itself mean lenders or potential buyers of bonds will be scared off in the future. In fact, the result could be expected to be quite the opposite if we finally manage to do the right thing policy wise.

Why would that be?

It is pretty obvious. Nobody will lend now at anything less than completely unacceptable (unaffordable) interest rates because they believe that the massive financial burden of the current and prospective size of Ireland's debt (government + bank losses assumed by government) will make it increasingly unlikely that they will get repaid.

However, if we quickly and it needs to be quickly stop the rot now we might have one last chance to write down a mass of bank assets and liabilities (which will mean bond holders), restructure them, likely with debt to equity swaps, and emerge with smaller banks with little concern over potential additional assets and liability write downs and a cap on the additional government borrowing that would be needed to fund the banks.

In effect draw a line right now under any potential future capital demands on taxpayers from the banks by putting them into nationalised administration (which I have mentioned before) and forcing the risk capital lenders to those banks to take the losses.

If we do that we then only (only!!) need to address the smaller (smaller!!) issue of general government finances in order to put a lid on government debt at a high, but not disastrous level - something around 130-140% of GNP.

And do you know what? People will lend to us again. They won't be looking back and thinking "well, they burned those bondholders last year", they will be looking forward and thinking "the losses have clearly been taken now and Irish banks and the Irish government are much better risks now". That is how markets work. Yesterday's loss is gone and irrecoverable. Markets look forward.

It still isn't too late, but it nearly is for Ireland.

Our banks need to be put under nationalised administration using special emergency legislation and restructured by defaulting on enough of the tier 1 and tier 2 capital (that includes senior bondholders) as required to make them unambiguously well capitalised with impairment free balance sheets.

End game approaching for Ireland - what to do?

Does anyone have a plan to get Ireland out of this financial quicksand that is sucking the country under as we try and stop anybody (except taxpayers) losing money on our failed banks?

Well, yes. Here is one I made earlier - over one year earlier:


But it doesn't have to be that way. The guarantee expires next year. The government can effectively renege by threatening to string out affairs until its expiry. This can be used as leverage to force the reconstitution of the banks balance sheets by wiping out current shareholders and doing debt-equity swaps on some bond holders to reestablish the banks.

If the shortfalls are too large the government could then force the banks to be declared insolvent and nationalise them on the basis that they tale only those liabilities they are required to - effectively deposits and secured creditors/bondholders. Then use taxpayers' funds if necessary to restore tier 1 capital. Only that way could you ensure that the burden on the taxpayer is kept to a minimum.

Tuesday, 23 November 2010

Keynes has a lot to answer for

Well, that might be a bit unfair. John Maynard Keynes was an exceptionally clever person. It is hardly his fault that people get all confused by what he was saying.

It is an almost undeniable fact that probably more than 90% of the population (maybe more) believe that macroeconomics can be understood by reference to what is nothing more than a basic accounting identity - a banal statement of equivalence:

Y = C + G + I + X - M

Economics begins and ends there for an alarming proportion of the populous and an even more alarming proportion of opinion formers and decision makers (especially my bugbear, "successful businessmen").

Let's get one thing straight. All that little identity tells us is that everything we produce must by definition be bought and/or added to inventories. That is it. There is nothing else in there of use to understand economics, or formulate economic policy.

For example, it does not:
  • mean that not buying foreign (imported) goods will increase our output or incomes
  • mean that increasing government expenditure will increase our output or incomes
  • mean exporting a lot will increase our output or incomes
I could go on, but I think you get the picture. This national accounting identity is just a simplified algebraic description of how we deploy our income. Economics is really (really) about how we create that income in the first place.

So what made me blog this rant today? Believe it or not it was our new IMF overlords in a tangental way. A news report this morning that an IMF paper has floated the idea of a lower income tax rate for women on the basis that they "tend to put more back into the economy than men". And we had a couple of accountants (christ!) and other economic ignoramuses proclaiming what a clever idea. If I had to appraise this argument for its intellectual efficacy I would tend to the technical. Ughhh!! What a load of tosh.

The premise, as presented by the media, is that women will spend more of their income - increasing the "C" in our accounting identity above - hence leading to more output and hence incomes. Output and hence income, we were told, would increase. Huzzah!! We've found the magic formula!!!

Now, it is entirely possible that the IMF report does not make such an argument but that is exactly what was presented and commented upon.

So why is this stupid? It is stupid because if (if) such claims about propensity to consume by the female gender were true, giving them lower taxes than men would reduce growth in our output and incomes. Yes, reduce it not just in one year, but by a small amount every year forever.

To understand why this is so you have to forsake your beloved accounting identity and accept the power of the supply side (mwwaahaahhaaahaahaa).

We create output and hence income by combining labour with capital to create stuff that is greater than the sum of its raw material parts. There are three parts to this process; capital (income we don't consume), labour (blood sweat and tears), productivity (the ingenuity possessed to make stuff out of other stuff).

In market based economies we become wealthier each year because we experience increases in two of those three areas (the amount of labour we have is limited at 24-sleep-eat-etc.). Productivity rises because humans, despite our clear collective stupidity are strangely collectively clever. We become more ingenious as time goes by and can make more stuff and more useful stuff out of less stuff every year.

Then there is capital. This tends to rise over time because we will save some of our income, preferring to defer some of our consumption to later years rather than simply live hand to mouth. That means we have an increasing pot of capital (per head) available to use to produce output and income.

And that is where these spendthrift women come in. If we tip the incidence of taxation towards men and away from women and they do indeed consume more of their income each year, we will reduce the rate at which we accumulate capital. Lower growth in our capital stock means slower growth in our output and hence incomes.

Sure, there will be a lot more bling bling about and we might feel richer, but we will be poorer and the opportunity cost will rise over time as we forsake investment for lipstick.

Do you doubt it? Ireland has just completed a nation wide experiment of this very theory. We consumed and consumed until we made ourselves the poorest country in Europe. We have no capital, that is why the IMF is filling up our hotel rooms.

Today's fun number fact - 125%


The total net foreign debt of Ireland expressed as a percentage of our annual income.

To give a point of reference, Australia is considered one of the most heavily indebted economies in the developed world due to running a substantial current account deficit for decades and has a total net foreign debt of 67% of annual national income.

The UK is 22%

Monday, 22 November 2010

Another fun number fact

Time for another fun number fact.


The value of Irish domestic banking assets (equivalently liabilities) accounted for by lending to one another, expressed as a percentage of annual national income.

For point of reference, the number for the UK - another over-banked country is 30%.

Rearrange for the following words to make a coherent sentence:

as, cards, as, of, house, strong, a


Thursday, 18 November 2010

Fun with numbers - today's fun fact

Want a fun number fact?


The current amount of "Repo" lending to Irish credit instutions as a percentage of our annual GNP. For those who don't understand jargon, that is probably a bit like going down to the pawn shop to borrow over half your annual income in order to buy this week's groceries down at Dunnes.

Stay tuned for another fun number fact tomorrow.

Friday, 12 November 2010

Mortgage forgiveness - an alternative

The "mortgage forgiveness" proposal is a bad idea. Firstly it does threaten to introduce as well as exacerbate moral hazard problems (these have been quite transparently glossed over by some of the scheme's proponents), but worst of all is that it will not have any material macroeconomic benefit. To suggest it will is absurd, to borrow a phrase.

The reason is because this scheme will only transfer wealth between parts of Irish society, when the problem is our complete lack of wealth in total, or more accurately our now massive net indebtedness as a country.

The proponents say it will address the "mortgage default overhang", which is essentially to say that it will allow further required contraction in the balance sheets of the Irish banking system by writing down those banks' assets. However, it will do so in exactly the same way that the hair brained NAMA scheme has and will. It will create a capital hole in the Irish financial system which will be filled by government borrowing. It didn't work for NAMA I and that was when Ireland was far less grossly indebted than it is now. This mortgage forgiveness will be NAMA II, where taxpayers are forced to pile even more of their money into those same banks from a far far more indebted starting point. It is a really really bad idea, especially because we have only just tried this stupid idea, it didn't work.

So what should we do? This is what we should do:

  1. Modernise Ireland's bankruptcy laws. There are many models in the UK, US etc., but they have similar features in that the force a crystallisation of loss on the debtor and creditor, the debtor is required to make as realistic reparation and there is a clear finite term (say 5-10 years).
  2. Repeal the bank guarantees - yes I have said it countless times since I declared it hair brained upon its introduction. Of course that leads to bank collapse, so you take them into nationalised administration under some properly drafted legislation (what they should have done in the first place) and begin capital restructuring talks with creditors while allowing them to continue business.
  3. End the political coercion that is stopping forclosure on mortgage holders who are defaulting on their loans.
  4. Let markets get at it.
What would this do? Well it would do the following that the "Times 12" proposal will never do:

  • It will have a beneficial macroeconomic effect. As banks begin to write down bad mortgages as they deal with them on a case by case basis, capital losses will be taken by the banks risk capital investors - mostly foreign - and not Irish residents. There will be a positive net wealth outcome for the Irish economy.
  • It will be much more efficient. The lenders themselves are best positioned to determined what mortgages will or will not ever provide an economic return and they can foreclose and take the write down under the modernised bankruptcy laws. Simply having "negative equity" won't be enough - nor should it.
  • Banks balance sheets will contract in a relatively orderly and proper way, with liabilities falling as well. Smaller balance sheet less encumbered by non performing loans.
  • This will be far more equitable. This won't represent the arbitrary transfer of wealth being proposed by the Times 12. Those who lose will be those who lent the risk capital to the banks, not Irish taxpayers who managed their financial affairs sensibly.
  • Reduced likelihood that we promote moral hazard. Although modernised bankruptcy procedures would allow a clear exit path for borrowers beyond the point of no return, it would still be onerous and clearly punishing. Effectively, having to work for your creditors and your creditors alone for 5 years or more isn't an attractive option.
  • It won't treat the existance of "negative equity" as a problem. It isn't People in negative equity have exactly the same fixed cash flow burden they anticipated when they borrowed the money. They still have their property and as long as they continue to pay off their mortgage there is no problem to try and "solve".

Wednesday, 10 November 2010

Mortgage forgiveness and moral hazard

Stephen Kinsella of Limerick University popped up on Newstalk this morning to tell the country that concerns that the floated mortgage debt forgiveness might cause increased problems of moral hazard as absurd, or somesuch dismissive noun. His argument is put here.

It wasn't a complete or particularly coherent argument, which is forgiveable given the live radio context, but I feel a need to point out that Stephen's performance leaves me feeling that his is the absurd position on this issue. And he can't be given the same forbearance for his blog posting.
It is worth parsing his argument to see how poor it is, riddled with omission, straw men and simple appeal to emotion.

Stephen makes three supposed points referring to moral hazard, conveniently labelled one, two and three in his post. Let's look at them:

"First...the Irish economy has already been
 pumped full of moral hazard because of the bailout of Ireland’s banks
and bankers"

Well, I don't disagree with this, but point out that the bank bailout was stupid and most likely has increased moral hazard, but for lenders of risk capital. What is at issue here is whether to compound one immeasurable level of stupidity (the bank guarantee/bailout) with another (mortgage debt forgiveness) which would extend the exacerbation of moral hazard from risk capital lenders to the borrowers as well - a type of "why stop now?" type of argument. Strange indeed. Stephen's argument might also seem to imply that we should all be allowed our share of moral hazard, that it simply isn't fair or that households should not miss out on this fun. I would characterise that as a rather strange type of analysis of welfare economics.

"Second, the moral hazard existed at the point of sale–the bank
 selling the mortgage had more information about the likely evolution 
of the market...

...Recent research has shown that rising house prices were driven predominantly by increases in the size of mortgages that banks were willing to give, meaning the banks were the engine of the housing bubble, not interest rates or population. The average person just wanted a house to live in."

I don't know how to interpret this. He makes a claim and doesn't support it. To state that "the moral hazard existed at the point of sale" and was manifested through the lender, suggests that the lender had strong belief when they made the loan that they would not be made to bear the cost of any default, over and above their contracted security. Does Stephen have any proof of that? I am not aware of anything that suggests that banks believed they could rely on anything more than the ability of the borrower to repay and the strength of the backing collateral (the house). So this claim is just absurd.

But Stephen then confuses this non-argument by going on to claim that house prices were being driven by the size of mortgages (well, d'uh Stephen, it was a monetary and credit bubble), but doesn't make it clear how that matters for his argument. It is simply a well accepted fact; people wanted/needed larger mortgages to buy property and took increasing personal risk (gearing) to do so, banks wanted/needed to make larger mortgages available and took increasing risk (gearing) to do so. If Stephen has evidence that either side had some information that led them to believe they had some "get out of jail free" card in the event that something went wrong he should actually state it. Otherwise he has not pointed out any moral hazard.

And Stephen then descends into something which is pretty deplorable for an academic economist. He resorts to argument from emotion: "The average person just wanted a house to live in". But I don't give Stephen full credit here. This is even worse than an argument from emotion, it is just plain stupid. There was and is plenty of housing available. People could have rented a house or apartment. Would that have sated this desire of the "average person"??? Moreover, this average person could have found "a house to live in" at a rental yield so low that it made the very idea of buying over renting totally irrational - in fact it was.

So to number three:
"Third, the worry is that these bailed out homeowners would start
 taking out more debt, thinking they’d be bailed out again. Think about
 this for a second from your own point of view. Say a bailout happens 
for you and your wife with a 600,000 euro mortgage on your home. Say through some mechanism the bank forgives 200,000 euros of the mortgage, you keep your home, and you continue to pay a reduced amount to the banks. You and your wife have spent probably two years getting letters and phone calls from banks and solicitors, you’ve gone through the stress of nearly losing your home. A note about the debt forgiveness exists on your credit record. You are not going to start running up debt again, and
even if you’d like to, you’ll be stopped. The moral hazard argument is flawed and useless. We should discard it."

This is flawed by not properly identifying where the issue of moral hazard is really concentrated. Increasing problems with moral hazard will come from all those people who will try to manage their financial affairs in order to qualify for a bailout. For example, we are probably talking large sums here, potentially multiples of gross annual earnings for individuals. People will be incentivised to make their financial position appear worse than it is, or heaven forbid actually deliberately make their financial position worse than it is (why bother with this saving lark, lets blow some cash on holidays etc.) as they reorder their priorities away from paying off their mortgage. Just like a lot of people tried to distort their financial position during the bubble in order to qualify for a larger mortgage, a lot of people will certainly try to distort their financial position in order to qualify for debt forgiveness.

And there is more. The moral hazard will in fact be most likely to affect the children of those people who get the bailouts, or those people who won't get the benefit of this bailout. They will be the ones watching risk being absolved and factor that explicitly or implicitly into their future decisions.

After that series of non-points Stephen then makes some intellectual doodles before signing off. They are all pretty specious, but I find this one probably the most unforgiveable for a supposed Economics professor:

"Fully cleansed, functioning banks, homeowners taken out of substantial negative equity and consuming and investing again, and a clear signal to the markets that Ireland has put its house–no pun intended–in order, may be worth it"

There is a serious ommission of fact that mortgage debt forgiveness will spark increased solvency problems for the banks - they are writing off yet more assets, OK - and not help to "cleanse" them, but require us to put more taxpayers capital into them under the current polices.

With that in mind I hope readers of this blog will immediately understand why I find this statement completely unconscionable. We are talking about a redistribution of wealth here. Ireland's economic problem is a hangover from a massive savings/investment imbalance. A mortgage debt forgiveness program will simply take capital from members of society and give it to some others - completely arbitrarily. Note that the capital might be "taken" via even more borrowing by government, which of course has to be repaid by taxpayers.

Back to Econ 101 for you Stephen. How does such a redistribution of capital either:

  • increase the total amount of capital available, or
  • increase gross saving in Ireland

It doesn't, unless the capital is coming from foreigners, say in the form of default on (foreign)bank bondlholders - but Stephen doesn't say that, nor does he show any indication that he understands that only with such an inward foreign transfer of wealth, would his argument hold water. That is a shocking, shocking piece of supposed analysis from an Economics lecturer.

No, our big mistake was the bank guarantee and subsequent bailout, as I have stated many times over. We should have taken AIB and Bank of Ireland under national administration at the earliest possible sign that they might fail (for "liquidity" or solvency reasons) and then recapitalised at minimum possible cost to the taxpayer, leaving shareholders and then bondholders progressively down the capital structure to take the losses. Thinking we can make debt somehow evaporate (when as I stated it is merely an act of transferring wealth) is seductive, but flawed and dangerous in equal measure. We risk merely compounding our problems and mistakes.

Monday, 8 November 2010

Let them eat cheese

If proof was needed that we have truly descended into the rabbit's hole, the Irish Government has helpfully announced their program to give away cheese to the masses. Of course, when I say masses I mean that elusive body of the population variously labelled as "the most vulnerable", "the poor", "those in need". In other words, that politically useful rhetorical devise; "the third person".

Once we all stop laughing and crying in equal measure, let's just turn to some economics to make some interesting observations and some random predictions.

  • The cost of this scheme in terms of packaging and distribution, verifying that the recipients as indeed "the most vulnerable" etc. most likely rivals the costs of handing everyone who qualifies a €20 bonus in the welfare payment.

If the reports are to be believed, vis:

The cheese is available in 12 x 1kg boxes from stores in Clondalkin, Portlaoise, Kilmacthomas Waterford, Cobh and Togher Co Cork from November 15th with a “minimum of one box per collection”.

(a minimum of 12kg of cheese each!!) we will have a nice little arbitrage opportunity opening up. Prepare to see markets do their stuff. So:

  • This could mean cheap cheese for everyone, as enough clever clogs see the opportunity to take a few boxes of their free cheese and sell it on. There may be attempts to restrict the sale of this cheese, but that is likely to futile as either nothing will be illegal about it, or a black market will simply develop.

And when this secondary, or black market for cheese develops, the demand for cheese via regular outlets, like supermarkets will fall. In order to prevent wastage, the price is likely to be discounted, potentially below cost in order to clear purchased stock.

Or, an alternative scenario:

  • Clever supermarkets recognising this potential cheese glut curtail significantly their cheese purchases over the next month. That might lead to a shortage of cheese in supermarkets. Riots in the dairy aisle shopping mums and toddlers battle it out for the last 500 gram block of red cheddar.

And of course the medium term consequences:

  • Cholesterol levels sour and heart disease takes off. The strain on the national health budget increases and our cheese binge starts to look like a big mistake.

Oh, how much fun it is to live in Ireland today. The comedy rolls on every day.