Stumbling into disaster

I am just back from a conference in Berlin that was attended by finance officials from a number of euro zone countries.   I must admit that what I heard left me with an increased sense of foreboding on the future of the euro zone.     To no great surprise, officials from stronger countries made it clear their governments are willing to pay a significant price to save the euro zone – but not any price.   What worries me most is the emphasis on restoring “market discipline” given concerns for moral hazard, including the continued threat of debt restructuring.   (The sentiment behind Deauville has not gone away.)  While I have no trouble in understanding this position from likely net contributors under enhanced risk sharing arrangements, it is a recipe for Italy and Spain being driven from the bond markets.   The concern of stronger countries for their own creditworthiness under guarantee arrangements was also emphasised – and, again, is understandable.  

As has been pointed out before, the main message from “second-generation” currency crisis models is very relevant.    Concerns about the willingness of policy makers to bear the costs of protecting a currency peg — or avoiding default — leads to increased expectations of those events, raising the costs of avoiding them still further.   It is all too easy to fall into a self-fulfilling, bad-expectations equilibrium. 

So what is the way out?   Stronger countries need to lay out what institutional arrangements they require to support enhanced risk-sharing arrangements, including some substantial form of euro bonds.   For the medium-term, credible institutional discipline must replace market discipline.   The present mixed approach is not working.   In deciding whether to accede to arrangements that would significantly diminish fiscal/banking sovereignty, all countries must recognise the likely path under the present course.   It might be a bridge too far, but at least we should not stumble into disaster. 

Who will pay for banking losses?

The WSJ has a really good piece by Gabriele Steinhauser and Matina Stevis on the core story of the Eurogroup meeting, which seems to have slipped past the domestic media somewhat. Yes, yes, they’ll get to Ireland’s debt in September/October. Grand. The key issue of just who pays for any losses within the ESM is not settled, nor is it likely to be any time soon. From the piece:

Germany’s finance minister said that even once the euro zone’s bailout fund has been authorized to directly recapitalize struggling banks, the lenders’ host government should retain final liability for any losses.

Wolfgang Schäuble’s statement early Tuesday indicated disagreements on how far the currency union needs to go to protect countries from expensive bank failures. His declaration, which followed more than nine hours of talks between euro-zone finance ministers here, clashed with those of other officials, who insisted that banks’ host states wouldn’t have to guarantee any support from the bailout fund.

The issue is hugely important for Spain, which risks being locked out of financial markets amid concerns over how a European bailout for its banks will affect Madrid’s ability to repay investors.

Fun times ahead.

It’s make your mind up time

Like many people, I suspect, I usually check in on Sunday night to see what Wolfgang Münchau has said this week. This week’s article was a cracker, and it’s hard to see where he’s wrong. Either governments decide to make the radical reforms that are needed, or monetary union collapses: the news from Brussels this morning suggests that they are not going to do the necessary any time soon. The Government and Central Bank have had a long time now to get contingency plans in place, and it would be nice to think that they had actually done so.

Update: for similar views, see Sony Kapoor here, and Karl Whelan here.

Irish Governance in Crisis

In a piece in yesterday’s Sunday Business Post my colleague Dr Niamh Hardiman  makes a plea for better understanding of the roots of our current crisis in weaknesses in governance institutions. Such an understanding is a precondition for effective reform. She addresses weaknesses in parliamentary scrutiny, the capacity of the civil service for appropriate engagement over policy making, and the effectiveness of the public service itself. She highlights institutional explanations for tendencies for public policy to favour sectional interests, but argues that understanding the institutional weaknesses is the key to addressing them. The article is behind a paywall, but a fuller, multi-author examination of the issues is available in a book arising from a UCD project on governance, Irish Governance in Crisis, edited by Niamh Hardiman (Manchester University Press, 2012).

Colm McCarthy: Fours years on yet not even a parking ticket issued

Colm writes in today’s Sindo on the outstanding problem of obtaining satisfaction from those responsible for the banking crisis within the banks. As usual there is a lot to think about and digest, but one piece stood out for me:

In Ireland, almost four years after the balloon went up, not so much as a parking ticket has been issued. Inquiries are under way by the Director of Public Prosecutions, An Garda Siochana, the Criminal Assets Bureau and the Office of the Director for Corporate Enforcement but none has yielded fruit. The Irish banking bust has been described by Central Bank governor Patrick Honohan as one of the largest, relative to the size of the country, which has ever occurred anywhere.

The snail-race by the investigating bodies is an embarrassment, has fed public cynicism and the belief that those responsible for the disaster will never be brought to account.

The socially corrosive effect this delay is having cannot be estimated. There has been at least one file prepared and sent to the DPP, but that’s it as far as we go. Colm has a gloomy outlook on the possibility of any redress coming via the Oireachtas:

It does not matter which Oireachtas committee undertakes the next incomplete inquiry.

The importance of the current account

The current account is the sum of the balance of trade, factor income and cash transfers. It is one half of the balance of payments, together with the capital account. The current account matters in every country for a host of reasons, but it is especially important for small open economies like ours. Here’s the latest data on Ireland’s current account, here’s that data in chart form.

CSO.ie

We see the imbalance within the current account throughout the crisis. Much of this imbalance came through the ‘services’ and ‘income’ channels, as we can see in this figure that simply decomposes the components of the current account over time.

Components of the current account.

There is a new working paper from the ECB by Ca’Zorzi et al which shows that, accounting for a host of other factors, the current account imbalance story is really the only one that matters. Once the current account become decoupled from what the authors call ‘fundamentals’, the wheels come off the bus. This paper should be food for thought for our policy makers.

Irish Economy Conference: Preliminary Notice

The podcasts and presentations from last year’s Irish Economy conference are available here. This will be run again in January 2013. The general reaction to the 2012 session was positive and we think it has a useful function and should be retained as an annual event held in January.  I wanted to post now to give time for discussion and suggestions for sessions. The layout will be similar to last year, with a potential for three parallel sessions depending on amount of quality speakers that are available. Comments on this blog directly influenced last year’s session so this is a good place and time to make general comments if people are interested in shaping the format and line-up. Alternatively, either me or Stephan Kinsella can be contacted with suggestions. Or use #ieconf as a hashtag on twitter

Journalists! Bonds are not Bills! Bills are not Bonds!

Today the NTMA announced Ireland will resume treasury bill auctions, the first since September 2010. This is a really good thing.

But this does not mean Ireland is “back in the bond market”, with all the baggage that phrase has for Irish people these days. We’re back in the Bill market. Journalists in particular should understand the difference between bonds and bills.

While both bonds and bills are debt obligations, in other words when you buy either a bond or a bill you are lending your money to the Irish government, and both are auctioned, bills are used as short term liquidity instruments, typically repaying the bill buyer in 3 months or 6 months or something like that, while bonds carry much longer maturities, usually 2 years, 5 years, 10 years, even 30 years, and are typically used to pay down other maturing bonds or to finance state expenditure. See these lecture notes, slide 218 in particular, for more details. Update: these ones are way better.

Thus Bills differ in their form and their usage, it doesn’t make sense to confuse them. While today’s announcement is a good sign, we shouldn’t get too excited over their issuance. Portugal has been issuing T-Bills throughout its time as a programme country, and even Greece got some away in May.

For these reasons we shouldn’t read too much into the yield and bid to cover ratios of these bills. It’s still a positive first step, but it’s not Ireland dipping its toes in the water of the markets, more like us taking off our socks near the pool.

The Devil is in the Principles

Twenty years ago this summer, Europe’s currency arrangement, the ERM, began to tear apart. Fixed exchange rates last as long as the markets fear that central banks can out-buy the sellers. The Bank of England ran out of reserves in September, making George Soros famous, and the system broke up in the middle of 1993. There was no buyer of last resort for the weaker currencies.

 

Under EMU the sovereign bond market plays the role of the forex market. There is no buyer of last resort for the weaker sovereign bonds. The unwillingness of the ECB to play this role means that Spain and Italy can be forced out of the market. Their total bond stock is approaching €3 trillion. Ongoing deficits and rollovers mean their gross issuance could not conceivably be financed by official lenders.

 

So they must be kept in the market or the crisis enters the endgame. The ECB has suspended its SMP (Securities Market Programme) which bought sovereign bonds in the secondary market. It pursued this programme in half-hearted fashion, worrying in public about the quality of the bonds it was buying. Sterling would have crashed out of the ERM more rapidly if the Bank of England had gone around bad-mouthing the quality of the sterling it was supporting back in 1992.

 

Selling sterling to the Bank of England, if the latter possessed unlimited reserves, would have been a mug’s game. Selling Spanish or Italian bonds to somebody with unlimited stocks of Euros would be suicidal.

 

The Brussels summit has opened the way for the ESM to buy bonds in the secondary market, so the ECB has been replaced with a buyer whose balance sheet constraint is known. This is actually a retrograde step. The ESM could quickly become Bank of England Mark II if a sizeable bond market run re-emerges.

 

Nobody in their right mind will short an asset into the Central Bank against money. They cannot run out of the stuff. Nobody can operate a credible reverse tap in the Spanish and Italian bond markets except the ECB, or some agency with unlimited facilities at the ECB.

 

Some useful decisions were taken at Brussels last week but the crisis will persist until this central issue is addressed. Spain and Italy cannot pay more than 4%, or maybe 4.5%, and retain debt sustainability. A reverse tap operated by the ECB places credit risk on its balance sheet and extends the moral hazard (liberally available to European banks) to Mediterranean governments. So the fiscal compact must be implemented and the political commitment problems resolved.

 

The devil is never in the details. The devil is in the principles.   

Gas interconnection, decision made

I blogged earlier about the draft decision of the CER on the pricing rules for the gas interconnectors.

The decision is now final. I find the document hard to read, because it assumes that you are familiar with the draft decision, and it rambles between the actual decision, decisions that might have been, justification of the decision, and responses to comments to the draft decision. This is what I think was decided:

  1. The interconnector will be moved, legally, from offshore to onshore.
  2. Interconnector capacity will be auctioned.
  3. There is a reserve price for the auction.
  4. The reserve price is the long-run marginal cost.
  5. If the auction does not cover the costs of the pipe-formerly-known-as-the-interconnector, the difference will be split over ALL gas suppliers.

I am not sure whether there will really be an auction, or whether the reserve price will always hold.

The contentious point, however, is the long-run marginal cost. This implies that Bord Gais will have a guaranteed income on its assets.

Instead of forcing BGE to take a hit on what might turn out to be a bad investment in interconnection, the CER forces gas consumers to make up the difference.

This is wrong in principle. It is a transfer from gas users to the owners of BGE. And it distorts competition.

We’re different, roysh? The decoupling of the Dublin property market

Today sees the launch of the fiftieth Daft Report, with a commentary by yours truly. To mark the occasion, and to mark five years of Ireland’s property market crash, Daft.ie and the All-Island Research Observatory at NUI Maynooth, have launched a property value heatmap tool. In a companion post to this one, I outline the tool, how it works and what it tells us about Ireland’s property market crash.

In this post, though, I’d like to highlight what’s in the report itself. The principal finding from Q2 was that conditions in the Dublin market do indeed look to have improved considerably since the start of the year. This has happened at a time when conditions elsewhere in the country are pretty much unchanged. It seems the decoupling of the Dublin property market from the rest of the country has already begun.

Continue reading “We’re different, roysh? The decoupling of the Dublin property market”

Get them while they’re hot (or cold): Heatmaps of property values in Ireland now available

As I note in the companion post to this one, today sees the launch of the fiftieth Daft Report, with a commentary by yours truly. To mark the occasion, and to mark five years of Ireland’s property market crash, Daft.ie and the All-Island Research Observatory at NUI Maynooth, have launched a property value heatmap tool. In this post, I’ll give an outline of what the tool is and does, and what we can learn from it.

Continue reading “Get them while they’re hot (or cold): Heatmaps of property values in Ireland now available”

Wolfgang Münchau states the obvious

Well, it seems obvious to me at any rate: here. If the EFSF/ESM still doesn’t have enough money to deal with Italy and Spain, then we are still in multiple equilibrium territory: if the markets don’t panic, they will be right, and if they do panic, they will also be right.

Don’t get me wrong: this was a good summit that made some important intellectual breakthroughs. But there are only so many things that one summit can do, and we have had so many bad summits that it isn’t clear to me that the system can now deliver the many needed reforms in time.

Let’s not get carried away

While the euro zone leaders’ summit certainly exceeded expectations, the shift from dire pessimism to elation in the Irish press reaction over the last few days seems overdone.    The big question across numerous articles seems to be how much of the €63 billion put into the banks will now be mutualised.   Unfortunately, I don’t see anything in the post-summit statement that leads me to revise a view that the chances of other European countries absorbing already crystallised losses in the Irish banks are approaching zero – the “similar treatment” statement notwithstanding.   More positively, the chances of beneficially refinancing the promissory notes/ELA arrangement looks to have  increased, which (depending on the details) could lead to a large NPV benefit, and thus significantly reduce the burden of banking-related debt.    While this might partly explain the fall in bond yields, my guess is that the majority of the fall reflects a decline in the chances of a major euro zone crisis following financing difficulties in Italy and Spain.    Excessively hyping what has been achieved runs the risk of later disappointment, undermining support for unavoidable adjustment efforts. 

Another worry is that the triumphalism on display following the summit runs the risk complicating German politics on risk sharing.   Thus far, the German government has moved incrementally, slowly bringing a sceptical electorate along with them.   The perception that “Merkel blinked” could lead to a backlash.  

So, yes, Friday morning brought some very welcome news.    But there remains a hard slog ahead.