Opening Statement to Oireachtas Banking Inquiry Post author By Philip Lane Post date January 21, 2015 My opening statement is here. The background papers are: Irish Banking Review 1997 Irish Banking Review 1998 Journal of Economic Perspectives 2006 Irish Crisis Paper 2010 NESC Background Paper 2010 Journal of Economic Perspectives 2012 Categories In Uncategorized 18 Comments on Opening Statement to Oireachtas Banking Inquiry ← Quote of the day → A moment of truth for the European project 18 replies on “Opening Statement to Oireachtas Banking Inquiry” @Philip Lane Full credit to you. Reading from your opening statement and in particular the excerpts, you were way ahead of the curve in predicting what could happen. “The proposal for a fiscal reserve fund from Lane (1998) is reproduced here..” Thanks for making this information publicly available. The most startling piece of information is your 1998 proposal for a fiscal reserve fund, of which I, probably like most of the population, was entirely unaware. In retrospect, it looks like a wasted opportunity to hedge against the possibility of a future crisis. It seems unlikely, though, that given the centrality of the Social Partnership model, and all it entailed, to government policy-making at that time, plus the clamour for ‘catch-up’ on welfare distribution, that it would have been regarded as politically unfeasible. This was also an environment in which there was a general feeling throughout elite political circles that the economy was ‘humming along’ nicely. For the first time in the history of the state, fiscal crisis was not, or at least did not appear to be, lurking around the next corner. Had the government of the day acted on a fiscal reserve fund proposal, it surely would have damaged their re-election prospects in 2002. Or at least been perceived to place this ambition at risk, as the politics of saving for a rainy day as opposed to looking after the welfare needs and other problems of society, would have proven politically unpalatable as well as being represented as mean-spirited by opposition and a host of interest groups. Would it have been possible post 2002? That seems unlikely too, given the failure to take policy action to curb the emergence of the property bubble etc. Also, I seem to recall you writing elsewhere that macroeconomics went out of favour around this period? In the end, the pensions reserve fund was squandered to a purpose for which it was never intended and, I guess, in due course we’ll all have to live with the consequences of that. ‘unlike’ should be ‘likely’ in para 2 above V. Useful. May one assume that the term ‘financial innovation’ refers, euphemistically, to the exponentially growing tentacles and sQuid-like reach of The Derivatives Death Star? … which continues to grow … BTW Philip, have you considered converting to modest marxism? With ‘critical intent’ this stuff would be incendiary! Just a thought … Thanks for the links . Very informative. “in a monetary union the central bank will only be concerned with stabilizing the price level and aggregate employment” and the ECB can’t even manage that. It’s more like micromanaging political/economic stasis. I suppose the next crash will be the same, if not worse. The crap models, the dancing while the music is playing and the asset mispricing. And the essence of tragedy, which lies in the relentless working of things and companies doing what they have always done. fyi “You don’t have to be a Catholic, or a Marxist, to acknowledge that Europe is beset by serious problems: soaring unemployment, the unresolved crisis of the euro, rising anti-immigrant sentiment, and the stunning loss of a sense of possibility for young Europeans everywhere – events made intolerable for many by the invisible bondholders, exorbitantly bonused bankers, and the taint of venality that spreads across Europe’s oligarchic political class. “Right in front of our eyes,” the Polish thinker Adam Michnik laments in his new book The Trouble with History, “we can see the marching parade of corrupt hypocrites, thick-necked racketeers, and venal deputies.” “Today, in our world,” Michnik argues, “there exists no great idea of freedom, equality, and fraternity.” http://www.theguardian.com/news/2015/jan/20/-sp-after-paris-its-time-for-new-enlightenment Well done Philip for explaining the rise of China into the global financial system and the “savings glut” which this spawned. I noted you attributed the phrase “plain vanilla property bubble ” to Patrick Honohan –in fact that phrase was used on page 6 of the Regling-Watson report ” This was a plain vanilla property bubble,compounded by exceptional concentrations of lending for purposes related to property-and notably commercial property”. Earlier Klaus Regling said that Alan Greenspan has admitted he was wrong. The following is an extract from ” The Subprime Solution” by Robert Schiller page 42: “Greenspan did eventually acknowledge the obvious reality of bubbles,but he never seemed to embrace the view that a good part of what drive’s people’s thinking is purely social in nature.—–Perhaps his lack of attention to bubbles reflected,at least in part,an overtly strong ideological alignment with some of the views of his former mentor,the philosopher Ayn Rand”. Perhaps Ayn Rand was the one of the sources of the financial crisis? “In 2007, the fiscal surplus in Ireland was just 0.2 percent of GDP, whereas it was 5.1 percent in Finland, 5 percent in Denmark, 3.3 percent in Sweden and 2 percent in Spain.” Philip, the opening statement is a tour de force in pulling together the multiple threads that made a huge crisis. Finland had a net debt of 70% of GDP in 2007 – 16 years after its economy tanked in the aftermath of the collapse of the Soviet Union. It now has a net debt of about 30% despite the demise of Nokia, the drop in demand for newsprint, a global steel glut and sanctions on Russian trade. Spain did have rainy day provisions that were relaxed in 2004 under pressure from the European Commission. Nevertheless, not one of its traditional banks – as distinct from cajas – collapsed. “Perhaps Ayn Rand was the one of the sources of the financial crisis?” Indeed she was – but in spirit rather than in person. However, both Milton Friedman and Greenspan were most willing and able acolytes. The theoretical underpinnings of their neo-economics were judged by some contemporaries as being daft and ultimately destructive of Capitalism itself. Worked out nicely. The starting point of any constructive critique of our ‘financial’ crisis has to be political. It was the politicians who deliberately and systematically loosened the legislative and regulatory frameworks and allowed the global financial interests to, quite literally, go mad. Not that the internal details are un-interesting: they are. They are symptoms – not the disease. Economic theorists have to seriously re-visit their subject: it has grievous faults, specifically in respect of what is known as “economic growth”. I have made regular reference to the foundational, yet rarely acknowledged, economic paradigm of Permagrowth. This posits that there be a “steady advance in specified physical entities and leveraged credit” . This explanation completely disguises the fact that an exponential (bubble-like) function is involved. See Fig 1: p7 (Lane 2011) for a very elegant depiction of the outcome of an exponential growth rate. Basically, its unsustainable. Another matter that economic theorists seem to have eschewed is the nature of leveraged (fiat) credit and its real outcome, contractual debt. The emission of leveraged credit (in all its different forms) must be considered as more and more risky as the amounts of available credit increase*, not less and less risky, as is usually asserted. Interest rates possess an inherent hazard and associated risks. As you lower interest rates, the immutable hazard abides but the financial risks escalate exponentially (it’s the leverage!) Debt, which starts the moment credit is drawn down for use (productive or speculative) has to be classified as a negative attribute of current G*P; that is, it subtracts from ‘economic growth’ rather than adding to it. Worse, debt is a compounding reality and a guaranteed, contractual form of negative, future income. The logical outcome (based on the Permagrowth paradigm) is that economic activity has to aggregate at a faster rate than the accumulating debt burden, until it can no longer do so. Economic activity is a physical process embedded in a physical environment. Debt accumulates exponentially absent the consumption of any physical resource, yet it requires the continuous conssumption of real, physical resources to enable the repayment of that debt. That’s a completely unsustainable situation. Look at that Fig 1. again! Lastly there are the issues of global labour markets, technological productivity enhancements (aka: competitiveness). Our economic theorists have a great deal of re-thinking and explaining to do. * QE? Good stuff, the 2006 excerpt particularly prescient. However, I take issue with one of the counterfactuals, always an easy thing to do. To be sure, if we had enjoyed the same scale of foreign sourced credit in foreign currencies outside of EMU the correction would have been much more painful. But that hypothesis is fanciful – no way would that level of foreign credit have been available outside of EMU. Up until the crisis the only perceived form of sovereign or banking risk in a Western economy was the currency risk. It was the perceived currency and otherwise riskless access to EZ credit that greatly exacerbated our crisis. I made that point incorrectly. Let be try again. The reason that we had a grotesque domestic credit boom fuelled by foreign lenders was because the currency mismatch was removed in EMU. Even if Irish people had developed the same voracious appetite for property foreigners would not lend them Irish punts and neither could the banks intermediate away the currency mismatch. Two articles which raise the fundamental political question that is now posed not just for Ireland but the Euro Area. http://www.ft.com/intl/cms/s/0/6e5532c0-a310-11e4-ac1c-00144feab7de.html?siteedition=intl#axzz3PrnOiCTq http://tinyurl.com/o8g3orx If politicians convince the European electorates everywhere – with the exception of those in Germany, and a few other creditor countries – that there is a tooth fairy, who is going to supply the cash to put under the pillow? All are contributing, nominally at least, to the bailout facilities. Taking on a heavier interest-rate burden than Greece herself must surely prove unpalatable, even in the other peripheral countries. Hi, DOCM. First, a delayed thanks for a link you provided on another thread. “– that there is a tooth fairy, who is going to supply the cash to put under the pillow?” We know who the Tooth Fairies are – the US Fed, the UK BoE, the BoJ and not to be left out, our very own ECB is ‘flying’ to the pillows* – of our EZ unregulated and poorly managed Wall Street look-alike financial institutions – not us Main Street sparrows who have significant contractural debts – many of which many of us can no longer re-pay! Its a political (fiscal) conundrum. Incomes from tax revenues are consistently behind expenditures. Will not be resolved easily. Eastern Ukraine absent the shelling? * “pillowing” in Japanese is quite interesting! The underlying figures from a blog post by Zsolt Darvas of Bruegel. http://www.bruegel.org/nc/blog/detail/article/1551-greek-choices-after-the-elections/ The crux of the problem is in this conclusion. “Even Syriza argues that Greece needs major structural reforms. Yet it may be difficult to find an agreement between Greece and the Troika, because many of the current plans of the Greek opposition parties are in diametric opposition to reforms agreed under the financial assistance programme.” The structures that need to be changed in order to bring about an increase in efficiency and production in Greece are not confined to the oligarchs which Syriza has in its sights. As the new government in Greece is made up of the far left and the far right of the political spectrum it will be interesting, to say the least, how the cold winds of financial reality will impact it. A couple of points: “Exit is not an option. Greece would enter another deep recession, which would push unemployment up further and reduce budget revenues, requiring another round of harsh fiscal consolidation: exactly what opposition parties want to avoid.” Merely saying this loud and often does not make it true, and there are good reasons to think that it may be false. For example, our own experience in Ireland with devaluation after the collapse of a currency peg was of strong growth in place of the predicted recession. There are other good reasons why many Greeks do not want to leave the euro. And there are good reasons why some do wish to leave. I think it is worth recalling that, typically, the Greeks with a strong stake in maintaining asset values relative to other European countries are not Syriza voters. Syriza has set out a broad platform of policies. If forced to choose from among them, the policy of remaining in the euro may not be its top priority. More than that, it may not see maintaining the consent of German voters for a currency union, and suppressing support for new parties in other EU countries, as being desirable. “Even Syriza argues that Greece needs major structural reforms. Yet it may be difficult to find an agreement between Greece and the Troika, because many of the current plans of the Greek opposition parties are in diametric opposition to reforms agreed under the financial assistance programme.” The Troika would have to be spectacularly dumb not to accept a credible alternative structural reform scheme. Syriza does not just have oligarchs in its sights. “The wrong answers to the Greek test have escalated the stalemate.” I picked this up from one of the Breugel papers. Wrong answers? Maybe its the questions that are the problem? Ask the ‘wrong’ question and you sure get a ‘wrong’ answer. EU is a club? I doubt it. Its a loose-ish aggregation of sovereigns, despite assertions and treaties to the contrary. Parliamentary politicians usually (though not always) tag along in the slip-stream of their electorates. Social control, whatever that means, may have its uses. But it can produce some pretty nasty outcomes. Fiscal ‘restructuring’ (don’t you just luv that term!) is simply a form of social control. Best not mess with folks’ lives. They are sort of attached to them. Bread they eat, but stones they throw. Ireland is an appendix-member of the Anglo-American, anglophone ‘club’. Aren’t we lucky then? Re: Peripheral European States Essentially Became Batteries for Financial ‘Wattage’ Listening to Philip’s discussion with the inquiry, on the 22nd January 2015. One has to learn to join together some dots. We also have to cease calling what happened in Ireland, as ‘vanilla’. There are many ways, in which people who know real estate finance, know that what happened in Ireland in the 2000’s, was a mile away from being ‘vanilla’ flavor, as the central bank governor is inclined to describe it. I don’t know what flavor it was, but it sure wasn’t vanilla. For it to be vanilla, one has to end up with some ‘product’, some output at the end of the day. In Ireland, we got a bubble, but very little on the side of output, of physical stuff, from the commercial real estate bubble. And this isn’t widely understood, or represented in the parliamentary banking inquiry. What few, or little, real estate professionals that we do have in Ireland, are probably viewed more as ‘sub-professionals’. And what few we have, who were trained in mature real estate financial regions, like Great Britain, had no clue, or couldn’t figure out, what the Irish were doing. So where does the central bank governor, get vanilla for ? ? ? Where ? ? ? Peripheral EU states, became battery storage of financial fire power, for the mainland. That’s essentially, what happened. At a larger level, China used north America, in the same way, and still does. How, and when to deploy, that wattage of financial fire power, is what is more important, than the amount of it, that one has. Because, simply put, asset bubbles in the western finance, no ensure that prices of go up and down quiet abruptly (reference, the ‘funds’ referenced below, who purchase an asset in Ireland at two, today, which cost somebody ‘twenty’ to acquire only a few years ago). It is a challenge of being able to access large funds, at specific times, and funnel them into buying up assets, when they are on the floor. One has to look at the period, leading up to the commercial real estate bubble in Ireland, in terms of what had happened in the global financial system. Essentially, there was a lot money, in search of a yield, at low risk, entering into the global financial system from the late 1990’s, post the Asian debt crisis onward. Of course, this spooked the mainland European ‘creditor’, institutions, . . . who had anticipated some serious kind of financial, global melt down, long before it ever did occur in late 2008, to 2010 (private institutions, spilling over into sovereign default risk, and market shut-out’s of sovereigns). The European creditor institutions knew, they had ‘Emergency Liquidity Assistance’, in existence in Europe, . . . which as the Inquiry committee, today learned, was what enabled some many ‘investors’, in Ireland to exit Ireland, so quickly as they did, . . . the vacuum, being left behind them, getting ‘back-filled’, with ELA, as the creditors rushed for exit. That is, the European peripheral states, became extremely good financial fire power battery storage mechanisms. The only financial engineering challenge really, was learn how to increase, the financial capacity of the ‘batteries’, that European peripheral states (or their financial institutions), became, for mainland European financial institutions. They increased the ‘capacity’ by encouraging the peripheral financial institutions to develop securitization financial engineering techniques. Think of it like ‘Electricity’, and the grid. What the Euro currency area created, above and beyond anything, was a European super-grid for finance (at a time, when investment was no flowing into any other infrastructure grids either – broadband, water, power etc). As was discussed in the Banking Inquiry, markets for low risk investment, became crowded out, driving down the risk-less rate of return in the markets. Essentially, before ever a commercial real estate lending bubble happened in Ireland. What we refer to, in Ireland, as a commercial real estate bubble, . . . , wasn’t even a commercial real estate construction, bubble. It was mainly about buying, of land, had hyper-inflated prices for that land, . . . and not a whole lot of commercial real estate construction happened in Ireland at the time, . . . essentially, over half the ‘blue prints’ for commercial real estate development construction projects, remained as blueprints, . . . and we got left with a lot of vacant, empty fields etc, which NAMA was set up to deal with. Essentially, all you had in Ireland happening, was a whole load of asset price inflation happening on big ticket items, that a couple of hundred blokes, who always seemed to appear in the Sunday newspapers, like they were football stars, transacted on, amongst themselves. There was no ‘output’ of product, of any great description, relative, to the amount of finance that was being stored, in these peripheral European finance batteries. I mean, one doesn’t have to look very hard, at the number of transactions completed in the period between 2004 and 2008, where something purchase for twenty, sells afterwards for two, . . . and one needs to understand, that behind nearly every one of those transactions, was a real blueprint, that never got realized. Both the governor of the central bank, and the economists who speak at the inquiry hearings, thus far, have described Ireland’s commercial real estate bubble, as ‘vanilla’. It was a commercial real estate bubble, that occurred without the production of any ‘product’ much. We pay for the bubble, and still don’t have the necessary ‘product’, that we can consume, and we need to consume. We have to kind of crank back up, the construction thing again now, to try and squeeze out some level of production. BOH. Re: Real Estate Finance I circulated a piece of literature, which I wrote, to describe of the A, B, C’s of real estate financial management, to the faculty at Trinity College, and some others recently. But essentially, what it boils down to, is that the central bank in Ireland, still don’t understand how real estate finance works. And more importantly, from a point of view of any parliamentary banking inquiry, why the way in which real estate finance operated in Ireland at the time of this ‘bubble’, . . . was not set up in any way, or engineered to generate output of physical commercial real estate product, . . . it was set up, to serve the creditor institutions, to Ireland’s private banks. I became aware of this, in a quite alarming way, when I listened through all of the preliminary ‘context’ phases of the parliamentary banking inquiry, thus far, had I realized, there was zero knowledge about real estate finance, present, in an inquiry, which sets out to investigate a problem, all to do with real estate finance. What we do have, are several world class economists, who are using ‘short-hand’, such as vanilla, commercial real estate bubbles, . . . basically, to describe something, which they don’t fully understand. The key way, in which one knows, that economists don’t understand real estate finance, at all, is when they begin to talk about banks (lenders to developers), and developers. They never know, enough, to even mention, the missing third party. In real estate finance, the two, . . . which economists in Ireland, journalists, commentators, media and the whole country, wants to talk about, . . . only get involved in the activity of real estate, for a short duration. They don’t have long term engagement with the process, at all. The whole activity, has to be funded by a party, who have nothing at all, to do with either banking or developing. There is no one, who talks about anything much, about the bubble, in Ireland, who seems to know even that much. What happened in Ireland, was that the banking and developer duopoly, never, realized any ‘product’, out to the funding institutions, who are the one who actually ‘own’, real estate. We have zero research investment, either, in real estate financial management in Ireland, from what I can ascertain. It doesn’t exist, despite the fact, that its cost us a generation practically, of youth. What we do have, are generalist economics faculties around the country, who do their best, across a whole plethora of things, . . . of which real estate, happens to be only, a fraction in that entire spectrum of research. And of course, any traditional funding, institution in Ireland, never got their hands on any physical commercial real estate ‘product’, . . . because the mainland European creditors, wanted the use of Ireland’s financial system, essentially, ‘as somewhere to put stuff’. When the individual from the European Union spoke to the inquiry, on the 21st, and 22nd, saying that Europe did not have institutions it needed, to manage the Euro zone properly, he wasn’t kidding. BOH. Comments are closed.