The Economics of “Don’t Scare the Horses”

I spent lunchtime at Newstalk defending the 46 guys article on the budget deficit against Dr. Garrett Fitzgerald. Podcast available here.

What it set me thinking about though was the following. As I’ve said, I think the statement in the article about the deficit is accurate and wholly defensible. However, what if it wasn’t? What if it was as badly thought out as Dr. FitzGerald seemed to think on Monday morning?

Would such an intervention actually cause problems for Ireland in the sovereign bond market as Dr. FitzGerald believes? The argument in favour of this position is something to do with its effect on “investor sentiment.” The argument against is that the sovereign bond market is populated by hard-headed individuals who rely on expert analysts that do their sums on revenues, expenditures and fiscal sustainability for every country and won’t pay any attention if some group of idiot economists put out a bad forecast.

I’d be interested in the thoughts of those who read this blog and have a closer connection to these markets than I do.

More generally, I do wonder whether “Don’t Scare the Horses” is just another version of the regular exhortation not to “Talk Down the Economy.” My feeling is that consumer and investor sentiment play a role in the economy but that this can never justify calls to limit free speech regarding economic fundamentals.

Update: A report on the latest Exchequer statement on the websites of both the Irish Independent and Irish Examiner states “The figures, published this afternoon, show a budget deficit of €18.7 billion for the first eight months of the year, compared to €8.4 billion for the same period last year.” Does this mean that the Independent and Examiner are now also being irresponsible and destabilising for referring to the Exchequer deficit as the budget deficit?

Sean Barrett on NAMA

TCD Economist Seán Barrett  argues against NAMA in today’s Irish Times. Note that Seán was not one of the signatories of the 46 guys piece from last week.

Lenihan: Current Share Prices Prove Banks Can’t Be Nationalised!

Yesterday’s Oireachtas Committee meeting left me more certain than ever that the NAMA “stockbrocking scenario” of something like a 20% discount is going to happen and that long-term economic value will be adjusted to deliver it. The transcript provides the strongest evidence yet.

The following exchange between Richard Bruton and Minister Lenihan shows that the NAMA pricing process has effectively already been decided. First, Bruton makes a point that I have emphasised on this blog many many times (for instance, here and here) which is that the Minister has effectively set a lower limit on the average NAMA haircut with his public statements:

If NAMA decides a €50 billion write-down is to be applied to the loans that are being transferred, and the shareholders’ funds are, for example, €20 billion, while the subordinated bondholders hold another €10 billion, it seems that the write-down will wipe out the shareholders and the bondholders. The legislation which purports to allow NAMA be independent in setting its prices has not shown us what will happen if NAMA, acting independently, wipes out the shareholders and the bondholders and is then left further below the water. That is a crucial issue.

On the one hand the Minister is saying that NAMA will be independent and that whatever happens with the valuation the cards will fall where they will and the State may have to put in more money. However, at the same time he is saying the banks will remain in private hands. He cannot pretend these two positions are consistent. To be honest, one cannot pretend that those the Minister engages as valuers – who are supposedly independent – will be immune from the knowledge that the Minister is saying every day of the week that at the end of this process the bank shareholders must be left intact. That may not be a written directive but it is certainly directive in its implications to those who are setting values. People who set values are fairly flexible in the way they work.

Lenihan’s answer is priceless. Read the following carefully. Referring to AIB and BOI he says:

Why would I outline the fact that there may be a residual or substantial shareholder interest left in these institutions if valuations established that their entire shareholder value was wiped out? The reason is on the basis of the information that I have at my disposal. This is not information that only I have at my disposal because markets have assessed that information in the context of their current share prices and rating agencies have used it in their assessment of these institutions. Were these institutions in the condition which Deputy Bruton suggests they would not have these positive market ratings and they would not have the degree of shareholder value they do. That is why in my public statements I do not envisage a complete wipeout of all shareholder interests in those—

Deputy Richard Bruton: What valuation of the loan book transferred to NAMA underpins those views?

Deputy Brian Lenihan: Bear with me for a moment. With regard to those two institutions, the current market assessment is based on their entire balance sheets which include the assets to be transferred to NAMA. Even on that basis the current market analysis is that they are viable trading entities based on their share price and rating assessments. That is why I speak as I do. I have to maintain confidence in a system in which world markets have confidence. When one speaks of the total wipeout of shareholder value it is unlikely to materialise on the basis of the information I have to hand and that will be the basis of my Estimates in the middle of September.

Now sit back for a moment and take this in.

Lenihan is saying that he knows the assets have a high enough value that the underlying losses won’t wipe out shareholder value. And he says that he knows this because the stock market says the banks currently have positive value! When he says “Why would I outline the fact that there may be a residual or substantial shareholder interest left in these institutions if valuations established that their entire shareholder value was wiped out? The reason is on the basis of the information that I have at my disposal” —it certainly appears to me that he is saying that even if NAMA came back and told him that the their asset purchases would render the banks insolvent, he would over-rule them, based on current share price valuations.

But anybody who has every studied financial economics knows that the stock market is valuing these banks based not on what the assets are truly worth but based on what NAMA is expected to pay. Bruton’s interjection is an attempt to explain this to the Minister. However, the Minister ignores it, ploughs on and essentially repeats the same point.

So there we have it. NAMA is a self-fulfilling prophecy. The markets expect something like a 20 percent discount. That’s built into the current share price. And the Minister will use the current share price to decide the discount.

It would be funny if it was happening somewhere else. To actually be living through this is very depressing.

A Green Investment Strategy

The FT carries an interesting article today on the decision by Norway’s sovereign wealth fund to increase its allocation to green-friendly investments in the developing world: you can read the article here.

Irish Society of New Economists

The ISNE annual conference takes place in UL on October 2nd. There are almost 60 speakers including PhD students from TCD, UCD, NUIG, UCC, NUIM and UL as well as researchers from a number of international institutions. The programme is now available on the link below. All are welcome to attend. No registration charge. The organising committee are Stephen Kinsella, Martin Ryan and Dominic Trepel.

link here