Crisis Prevention

The Irish economy is well removed from a full-blown financial crisis.   (I take it that the outstanding feature of such a crisis is the inability roll over liabilities.)  Even so, it is useful to review, with the Irish situation in mind, the list of crisis-prevention actions that received broad assent after the Asian crisis.   A reasonable overall assessment is that Ireland is still in a relatively strong position, but it is worthwhile to concentrate on minimising the remaining tail risk.    Here is a partial list: 

Exchange rate regime:  Avoid soft pegs.   This became known as the “bipolar view” – completely fixed or freely floating exchange rate regimes are the least crisis prone for countries with open capital accounts.   (See here for a recent thoughtful account.)  Being part of the euro zone is an unmitigated blessing in this regard. 

National balance sheet:  Avoid serious currency and maturity mismatches.  Here again the ability to borrow in one’s own currency is a huge advantage.   It also appears that the NTMA is doing a good job managing the maturity structure of the national debt.   The existence of the NPRF is also fortuitous – even if initially put in place for another purpose.   It should be viewed as a critical liquid reserve and not tapped as an easy source of funding.  Although no one likes to hear about IMF intervention or bailouts from our EU partners, I see nothing wrong with careful contingent planning and agreements.   I think it is highly unlikely that Ireland will need such funding.   But I think it is even less likely if arrangements are in place to smoothly access funding under extreme circumstances.   This would be a clear signal that the government will do everything possible to pay its debts, and would limit the risk of falling into the bad equilibrium that Philip Lane discussed in yesterday’s comments. 

Macroeconomic management:  Avoid destabilising fiscal policies.   Although Irish fiscal policy comes in for much deserved criticism, the dramatic reduction in the net debt put the country in a strong initial position.   Unfortunately, the running of a structural budget deficit during the property boom and the reliance on asset-based taxes left the country vulnerable.  The key question now is what deficit can safely be run.  One plausible view is that significant short-term consolidation is required to protect creditworthiness.   The danger is that this will deepen the recession and potentially even deepen the fiscal hole.  An alternative approach is to make the minimum adjustment necessary to show that the public finances are under control – clearly not a risk-free strategy either.  This debate will continue. 

Transparency:  The combination of non-transparent financial-sector balance sheets and implicit or explicit government guarantees is lethal.   It is indefensible that analysts are still trying to figure out how bad the bank balance sheets really are.  An open, Obama-style stress test is urgently needed to reduce uncertainty.

Regulation:  Err on the side of prudential regulation.  Evidently, the emphasis on prudential regulation lost out in the ever-present tradeoff between encouraging innovation and minimising systemic risk.   We have now had further confirmation of the tendency of financial markets to produce bubbles and the incredible damage that ensues when those bubbles burst.   There needs to be root and branch reform of the regulatory system to restore confidence in the system and ensure that balance sheets are never allowed to accumulate such vulnerabilities again.

3 replies on “Crisis Prevention”

“Unfortunately, the running of a structural budget deficit during the property boom and the reliance on asset-based taxes left the country vulnerable.”

I would say, “the reliance on asset-transfer taxes” aka stamp duty and developers contributions. A residential property tax would have dampened the property boom while ensuring greater fiscal stability (receipts are less procyclical than income or sales tax).

What is important from a fiscal point of view is not really the size of the budget deficit over the next few years, but the putting in place of a credible plan to restore budgetary equilibrium over the medium term.

This should include a phasing in of residential property tax, a diversification of the tax base, increased carbon tax and sensible spending cuts.

Sensible spending cuts doesn’t have to mean war with the public sector unions. Personally, I question the wisdom of the current capital budget commitments within this context. Most of the CBAs done to support roads and metros were (insofar as we can penetrate the veil of opacity behind which dubious commercial confidentiality clauses hid them) done on ‘benefits’ estimates that are now badly out of date.

Some projects, such as CIE’s grandiose Interconnector, never seemed to make sense. Others, such as the Metro North, were marginal at best. And the entire roads programme should be parked (pardon!) until someone sees the first 09 registered car (late April, I’m guessing).

@JohnMcHale: regarding fiscal policy – “An alternative approach is to make the minimum adjustment necessary to show that the public finances are under control” The only issue is that the ‘minimum amount’ will likely be impossible to gauge ahead of the fact because the collapsing tax take is undoing every forecast made. So the reality is that we will need to forecast ahead of the curve in order to match action with position, thus we should probably be taking harder measures in advance.

On the point of regulation, I have my doubts, Ireland is competing with Luxembourg and other countries for financial companies headquarters, if we regulate beyond our competition it will drive jobs out of this jurisdiction and into others.

Deborah Fuhr (Managing Director with Barclays Global Investors) gave a talk on ETF’s today to CFA Ireland and one of the questions asked was about how Ireland is working hard to bring in ETF Market Makers, aiming to do so on the back of our ‘financially friendly environment’, and what else could we do to attract companies. My fear would be that we remove motives for coming here. Stiff regulation is not generally in the list of ‘reasons for doing business with countryX’

Regulation will probably go beyond the level required in the same way that it failed to be at the level required for the last ten years. And of course there will be other countries more than willing to relax rules for jobs, the majority of the hedgefund industry is proof of that.

in a nutshell, root and branch regulation – to work correctly- will likely have to be inhibitive and process/reporting oriented, innovation may have to be the price of stability if that’s the case.

Indeed, asset-transfer is a better term. I agree with your point about the medium-term framework. To state the obvious, the challenge will be to make this credible without significant adjustments in 2009 and even 2010. Base broadening must be the way to go. Large increases in headline tax rates will have greater salience for households and businesses. High marginal rates will also harm competitiveness and productivity over the longer term.

You’re right, Identifying that minimum amount is indeed easier said than done. I think it is fair to say that the mainstream view is to puruse a fairly substantial consolidation in the reaonably near term. I certainly see the arguments: reduced uncertainly might lead to increased spending (expansionary fiscal contraction); a reduced deficit now could avoid an even more draconian forced adjustment later on; more pain now will lead to a more rapid restoration of competitiveness, among others. Compared to others, I probably put more weight on the risk of a vicious circle on collapsing demand and a worseing fiscal/credit picture. Weighing the bad options, I lean to trying to run the largest deficit the country can get away with. I believe those CDS numbers are mainly a response to the guarantee. The problem is less the flow of new debt than it is the risks associated with rolling over the massive stock of existing liabilities (notably the guaranteed bank debt). That is why I emphasised issues such as transparency on bad debts, maintaining liquidity to reduce the risk of a rush for the exits (even worse than a “sudden stop”), and limiting fiscal contraction to lessen the extent of bad debts outside the property sector. I am well aware this is extremely risky. But I still think better than the alternative.

On your regulation point, lax regulation to attract certain segments of the financial services industy strikes me as too high a price, both reputationally and in risking balance sheet vulnerabilities in the furture.

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