The Central Bank’s new PCAR statement hasn’t yet been linked to on the site so here it is. This is the most detailed statement released yesterday in relation to the future of the Irish banking sector.
Month: November 2010
It is time to dust off old ways of thinking about the Irish economy that were useful in the past.
In the long run, migration sets a floor to Irish wages. It has been thus ever since the Famine of the 1840s, and I don’t believe that the Irish have become less mobile in the last 20 years. Now, a lot of Irish wages are still high by international standards, but eventually as ‘internal devaluation’ proceeds, and as peoples’ living standards are lowered as a result of tax hikes and cuts to public services, it seems inevitable that the ‘migration constraint’ will start to bind again.
Once this happens, then very roughly speaking the size of the Irish economy will be largely governed by relationships of the following sort:
w(1-t) + b + P = E
where w is the wage (which determines employment and output, for given levels of the capital stock and technology); t is the tax rate; b is the value to workers of the public services they receive; P is the premium we enjoy as a result of living in Ireland; and E is the living standard which we can enjoy overseas. If the left hand side of this equation falls too far below the right hand side, people will leave until equilibrium is re-established.
Once we hit this constraint, either because w falls, or t increases and b declines, adjustment in the economy will be more quantity-based and less price-based than it has been to date.
And it gets worse, since t and b depend inter alia on the levels of output and employment. There are fixed costs to running a state, and the debts we are now being saddled with are not population-dependent. You don’t have to be Paul Krugman to see the potential for some pretty nasty feedback loops here.
What can politicians do? The most obvious thing to do is to minimize the debt overhang facing this State, so that t is not higher, and b is not lower, than they otherwise would have to be. Less obviously, if politicians — not the existing ones, obviously, but an entirely new political class — can increase P, by providing people with a political project for national renewal that they can buy into, this might also help convince some people at the margin to stay at home. This is not just essential for our democracy, but for the economy as well.
When a country finds itself overburdened with debt, the solution – if the debts are denominated in its own currency – is to inflate its way out of the problem. Debt is denominated in nominal terms so inflation reduces the real debt burden. Ireland cannot do this, but the ECB can. It would not do it for Ireland or Greece or Portugal alone but if Spain comes under attack, given its size relative to the European Financial Stability Facility, this option will be forced up the agenda.
What would inflating our way out of the debt entail? It can be seen as a type of orderly default. Assume for the sake of argument that the ECB is the owner of all Irish bank bonds; the Irish taxpayer currently owes these funds to the ECB. The ECB could accept a debt for equity swap, which would mean a substantial haircut, so that it – rather than the Irish taxpayer – now owns the banks. It recapitalises them by printing money and then sells them on. The downside is higher European inflation (it will have to take similar steps all across Europe because many banking debts are in fact to other banks, meaning that many will require recapitalisation) and a higher risk premium on all European debt. The risk premium could be moderated though by a pan-European regulatory system which would tackle one of the design flaws in the entire single-currency project.
The major design flaw was that there was no mechanism to tackle asymmetric (i.e. region-specific) shocks. The US has a huge federal budget which absorbs a major share of such shocks; e.g. if California goes into recession, it pays 25 cents less in federal taxes for each dollar its income drops, and it receives 10 cents more in federal funding. There is no such “fiscal federalism” in Europe (the nearest to it, the Structural Funds programmes, transfer about one cent for every dollar gap in income). Asymmetries prevail however, as is evident in that the business cycle in peripheral countries such as Ireland is out of sync with Germany and the core eurozone countries. This design flaw featured strongly in contributions made by Kevin O’Rourke, myself and others (all of us at the UCD School of Economics at the time) during the Irish national debate on whether to join the single currency. So Spain and Ireland got very much lower interest rates than were appropriate over their respective booms, which fuelled their property bubbles. The problem could have been reduced, though not eliminated, by tight pan-European regulation of the financial system.
These design flaws must be tackled in one way or another if the eurozone is not to stumble from crisis to crisis, though it is doubtful that there is the political will for substantial fiscal federalism. There is no painless way out of the current crisis, but inflating our way out of the debt and coming to grips with the design flaws look to me to be the least painful option.
I try to make these points in a politics programme recorded several days ago and due to be shown on RTE when the EU/IMF announcement is made. They’ll only use snippets so I’ve tried to join up the dots here.
It is a day for taking stock after an extraordinary week. On Wednesday, the Government unveiled its four-year plan for stabilising the debt ratio with about as much political acceptance as could be expected. Yet by the end of the week the expected probability of default on sovereign debt implied by bond yields had increased, and that was despite the imminent announcement of the details of an international rescue package. It was also a week in which those advocating sovereign default—on State guaranteed bank debt and State bonds—were advancing, while those arguing that creditworthiness could still be restored were in retreat. I think it is worthwhile to reflect on the two broad views.