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.

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.

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.

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:

http://ntma.ie/Publications/2010/SubDebtBurdenSharing.pdf

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?

Anyone?

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:

http://geckkosworld.blogspot.com/2009/08/more-nama-debate.html

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.

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.