Author: Colm McCarthy

Use of the phrase ‘productive investment’, without chapter and verse, and within the hearing of job-desperate politicians, is dangerous.

No matter how bad the economic outlook, foolish policy measures can always make it worse. The spectre of politicians seeking to create 100,000 jobs through extra public spending is every economist’s nightmare. The government has announced a New Era programme, funded through privatisation proceeds or otherwise, intended to create 50,000 jobs in the state sector and another 50,000 elsewhere. The state’s 50,000 are apparently to come mainly in the water, telecoms and energy industries, the remaining 50,000 through some mystical process yet to be disclosed.

 

With the unemployment rate in the mid-teens there is inevitable pressure on government to do something, or at least to appear to be doing something, and it is difficult for governments to preach patience when it comes to job creation. However it is inconceivable that sustainable employment on the scale envisaged can be magicked into existence through initiatives from above. The previous government in 2009 produced a ‘Smart Economy’ plan to produce, coincidentally, 100,000 jobs, and which has to date produced no more than sustenance to public expenditure dependants in the universities and barrow-loads of public relations.

 

Job creation schemes will win plaudits in the popular press and gratitude from subsidy junkies in the business community. But they cost money we do not have and cannot borrow. Diverting more funds to public capital ‘investment’ presumes that worthwhile projects are available. Indeed the scale of the New Era scheme presumes that such projects are abundant. Little detail is available on the projects to be pursued, an unacceptable feature in itself. Major commitments should never be made until the details have been scrutinised.

 

The three sectors indicated as having job potential, energy, communications and water, have one thing in common. These are capital, rather than labour, intensive businesses. Once the construction of new facilities is complete, it is not clear that these industries need large additional workforces on a continuing basis. In any event the total workforce in these three sectors is currently about 30,000. It is inconceivable that tens of thousands of extra permanent jobs are required in these areas. The electricity industry has been shedding jobs over the years and I have yet to meet anyone who believes that the ESB is understaffed. The gas distribution network now reaches all of the urban areas in the country that can be served commercially, so there is no job potential there either.

 

As for water, the government intends to meter all users, but this only has to be done once. There will be no permanent jobs in the once-off installation of meters, which will presumably be read remotely, so no jobs there either. The government’s intention is to create a single national water authority to replace the current inefficient and fragmented system of delivery through city and county councils. This is presumably intended to create opportunities for economies in staff numbers, not for a hiring fair. The merger of the regional health boards into the HSE seems to have been a disaster, not least in the creation of new layers of expensive administration. Surely the government is not planning a HSE for water?

There was a depressing discussion of these matters on RTE’s The Week in Politics programme last Sunday evening which paraded three Dail deputies, a junior minister and an RTE anchor none of whom seemed to grasp any of the issues involved. A recurring notion, apparently shared by all five, was that the dividends receivable from state companies (a surprisingly modest sum given the amounts of capital they consume) constitute a recently-discovered treasure trove freshly available to finance job creation schemes. These dividends are part of the government’s current revenue and are already spoken for. A further illusion shared by the participants seems to be that devoting privatisation proceeds to debt reduction, rather than to the New Era schemes, would be tantamount to wasting the money.

 

Patience in pursuit of a feasible macroeconomic plan will halt the rise in unemployment and eventually deliver a recovery in the demand for labour. This is the declared view of the government itself. The strategy of reducing the deficit over the currency of the EU/IMF rescue deal and seeking to stabilise the rocketing national debt is the best plan available and will be de-railed by half-baked and panicky job-creation schemes. 

 

The government seems to lack the courage of its declared convictions. If the macroeconomic strategy is to be subverted with ill-considered job creation schemes, the return to a better jobs market will be delayed. Fortunately the deployment of privatisation proceeds for any purpose other than debt reduction requires sign-off by the troika of EU, ECB and IMF. They should ask the government to explain, in detail, how this plan to conjure up100,000 jobs contributes to national economic recovery

The programme for the Dublin Economics Workshop 2011 Economic Policy conference, to be held in Kenmare, County Kerry, October 14-16, is as follows:

Friday October 14^th.

18.00 Understanding the Irish Banking Crisis

Dermot O’Leary (Goodbody Stockbrokers), Don Walshe (UCC): Debt De-leveraging, the Banks and Economic Recovery

Cathal Hanley, Andrew Rae (Competition Authority): Competition, Financial Stability and the Irish Banking Crisis

Pat Farrell (Irish Banking Federation): Building a New Banking Architecture

Philip Lane posted on this topic earlier in the week and it was my subject in this week’s Farmers Journal too:

Without breaking the speed limit, it is now possible to drive from the outskirts of Dublin to Cork’s Dunkettle roundabout in a little over two hours. Similar time savings have been made possible on the other inter-city routes and the country has, for practical purposes, become smaller. The improvement of the national road network is one of the few unambiguous dividends from the bubble. 

 

On the busiest routes between the capital and the main provincial centres, car journeys are just one option: you can also fly, take the train or catch a bus. The improved road network is good news for bus operators, who can now offer a far better public transport alternative to the car. But it is very bad news for internal air services and for the loss-making Irish Rail. These two options have become markedly less competitive with either car or bus, an outcome which was both predictable and predicted. A rational government would have planned for increased reliance on inter-urban bus services and would have avoided costly, and pointless, subsidies to air and rail services that were bound to lose popularity as motorway development favoured car and bus. There is no absolute need for four different ways of getting to Cork.

 

Rationality however dawns slowly in the make-believe world of Irish transport policy. The government has presided over a massive investment programme in the railway. No less than €2.5 billion has been spent on mainline rail investment over the last decade. The result is that Irish Rail has provided large increases in frequency and capacity despite the obvious threat to passenger numbers. On Dublin-Cork, fifteen trains per day now operate, compared to half that number a decade ago. They offer journey times that are now quite uncompetitive with the car.

 

Air services between Dublin and Cork are not provided by a state-subsidised operator and the reaction has been very different. There will shortly be no scheduled service at all between Cork and Dublin. Ryanair have pulled out, following previous exits by Aer Lingus and Aer Arann. At one stage there were up to a dozen flights a day between the two cities. Ryanair cited passenger migration to the new motorway as a principal factor in its withdrawal announcement.

 

All three airlines which have operated Dublin-Cork services over the years are commercial companies which cannot sustain loss-making routes and their decisions make perfect sense. What precisely is the point though in pouring €2.5 billion into rail investment when a motorway network connecting the same towns and cities is under construction? Did nobody in the Department of Transport foresee what was going to happen?

 

In addition to enormous chunks of free investment capital, the railway enjoys large operating subsidies and a highly restrictive licensing regime for competing bus services. If you fancy running an express bus from Cork to Dublin, without subsidy, forget it. You will not be granted a license. Irish Rail continue, remarkably, to campaign for yet more capital ‘investment’ in the railway – on the grounds that it has become less competitive on inter-urban routes!

 

The government has wisely curtailed capital spending and withdrawn operating subsidies at some of the regional airports, of which far too many were built. The same logic now needs to be applied to the railway. The sheer expense of rail-based public transport systems is invisible to the travelling public, who pay only a portion of the operating cost in fares and none of the capital cost. But the bills of course arrive at the door of the Exchequer.

 

Over the next few weeks, ministers will resume their consideration of the options for cutting expenditure in the years ahead and should assess with a jaundiced eye the rail schemes for Dublin. The most notorious of these is Metro North, a plan for an underground railway through Mr. Ahern’s former Northside constituency serving Dublin Airport. This scheme has been in the plans for many years even though no cost estimate is available. The construction bill would run to several billions, plus the inevitable operating losses. All of this despite the fact that Dublin Airport is easily accessible as things stand, with a road tunnel, built at a cost of €700 million, providing a new link from the city and non-Dublin users able to use the upgraded M50.  

 

There are also schemes to build a new underground railway in the city centre and plans for more tram lines. Sizeable sums have already been spent on designing and planning these projects. But there has been a noticeable drop in traffic congestion in the city recently and parking is easier. The government is flat broke and all of these fancy rail investment schemes should now be put on the long finger, or just abandoned altogether. It is not clear they ever made sense, even when we thought we could afford them.  

From this week’s Farmers Journal, with acknowledgement to Gregory Connor:

 

The state ‘bad bank’ NAMA has bought troubled loans at steep discounts from the Irish-owned banks at a cost of over €30 billion. Many of these loans cannot be serviced by the builders, developers and property speculators who borrowed the money in the first instance so the collateral, in the form of completed and uncompleted buildings and development land, is being seized by NAMA. The intention is that NAMA will realize these assets over time. It has sold very little to date but the clock is ticking and NAMA is due to be wound up within ten years of its inception, so there are just eight-and-a-half years to go.

 

Some of NAMA’s assets are in the form of completed residential property. Outside Dublin the market appears to be pretty slow, with only a trickle of transactions and very little availability of mortgage credit from the banks. There seems to be a bit of a buyers’ strike too – buyers with cash see no urgency about doing deals until prices dip a little more, and asking prices remain unrealistic in many cases.

 

So NAMA is getting impatient and has come up with an attractive-sounding wheeze: if you can get a mortgage to buy a home from NAMA, they will throw in, for free, an insurance policy which covers the risk that prices could drop further.

The scheme would work like this. Nama reckons a house it has for sale is worth €100,000. The purchaser is asked to put up €10,000 in cash and get a mortgage from a bank for €72,000, paying NAMA €82,000 in total.  Nama notionally pays itself the remaining €18,000 and records the house as sold at €100,000.  After an agreed period, say five years, if the fair market value of the house is more than €82,000 the purchaser must pay NAMA the difference up to a maximum of €18,000.  If the fair-market value of the house is €82,000 or less, the homeowner pays no more.

Assuming the initial €100,000 valuation is reasonable, this is a good deal for the purchaser and a bad deal for NAMA, which can never get more than the reasonable value of €100,000 but could get as little as €82,000. In effect, NAMA has given the purchaser a valuable price insurance policy for free. Gregory Connor, an economics professor at Maynooth, has calculated that the discount being offered to the purchaser, allowing for the value of the free insurance policy, is pretty big: on plausible assumptions, the buyer is getting a discount of €12,000 or so.

Before you rush off to phone NAMA, bear in mind that you own NAMA, or more correctly, you will pick up the tab if NAMA loses money, since its debts are on the state balance sheet. The scheme has a number of other drawbacks. Not everyone is an economics professor at Maynooth and able to work out the sums. The scope for confusing purchasers (and the taxpayers) should be clear. Moreover NAMA is not the only, or even the main, seller of residential property in the years ahead. The non-NAMA banks (ones such as Ulster and National Irish) also have re-possessed assets to sell and there are even a few non-bust builders out there trying to stay afloat through selling completed dwellings. Plus there are tens of thousands of individuals interested in selling every year in the normal course of events. None of these people can offer the big upfront discount and assumption of risk built into the NAMA scheme, since they do not enjoy the comfort of reclining on the state’s balance sheet. The NAMA scheme, in brief, could seriously distort the market, and looks anti-competitive. The Financial Regulator and the Competition Authority could have some things to say on this aspect before too long.

The banks have finally been re-capitalised and are now better placed to recover their ability to hold on to deposits. There are prospective purchasers in the residential market who must be a reasonable risk for 75% or 80% mortgages, provided prices are realistic. No doubt NAMA is fearful about the ‘realistic’ bit, but what value is there in anything other than market-clearing prices for residential property at this stage? One real drawback with this scheme is the temptation to use it to hold prices up artificially. The best outcome for the residential market is a more normal flow of mortgage credit to solid borrowers and the discovery of a lower price level which clears the over-supplied market steadily over the next few years. If NAMA paid too much for some of its assets, that is unfortunate but there is no point compounding the error through financial engineering gimmicks which distort further an already dysfunctional residential market.  

In yesterday’s Sunday Independent, noting that Italian and Spanish ten-year yields had closed Friday at just under 5.30 and 5.70 respectively, I wrote:

‘The sole priority for the Eurozone should be to prevent the spread of bond market contagion to Spain and Italy, launching a new financial crisis on a scale beyond the rescue capability of the EU and IMF. If the crisis affecting Greece, Ireland and Portugal can be confined to those three countries there is a reasonable chance that Spain and Italy will retain access to the markets. If the contagion-spreaders in control of European policy continue the shambolic performance of recent months…… Spain and Italy will be swamped and the costs of resolving the Greek, Irish and Portugese problems will begin to look like a bargain. The Spanish Treasury managed to sell some three- and five-year bonds during the week….. But at some stage solvent-for-now issuers such as Spain must face the music in the ten-year market or their outstanding debt bunches shorter and shorter. If the Spanish ten-year interest rate edges much above 6%, the game will probably be up.’

Spanish ten-year yields breached 6% this morning, with Italian yields approaching 5.7%. EU Finance ministers are meeting this evening and might ponder this comment from Reuters:

‘Gary Jenkins, head of fixed income at Evolution Securities, said that while Italy is still a long way from the tipping point in terms of bond yields — markets have focused on yields of 7 percent as unsustainable — recent experience shows how quickly things can get out of control. Greece, Ireland and Portugal spent an average 43 consecutive days trading over 5.50 percent before they went north of 6.00 percent on a consistent basis, Jenkins said. That fell to an average of 24 consecutive days before rising above 6.50 percent, and just 15 days before the 7.00 percent level was breached on a consistent basis.’

In a low-growth economy like Italy and with an inflation target of 2% I am not confident that the ‘tipping-point’ is as high as 7%. But not to worry, the EU Commission is on the case, this from RTE:

The EU has called for a ban on rating agency decisions on countries under internationally-approved rescue packages. Speaking in Brussels, Internal Markets Commissioner Michel Barnier also said that governments should be fully informed before being downgraded by ratings agencies.

So the agencies would have to quit rating Greece, Ireland and Portugal, but could fire ahead rating Italy and Spain. Jose Manuel Barroso, the EU Commission president, also targeted the agencies last week, alleging market manipulation no less, and anti-European bias. The problem, in the estimation of these two EU luminaries, has been caused by the ratings agencies. With no Plan B apparently, the failure of Plan A needs to be assigned somewhere, and US ratings agencies will do fine. 

What precisely is the proposal of the EU Commission to deal with the contingency that Spain and Italy are forced to exit the bond market over the next few months? 

Meanwhile the Italian authorities have banned short selling of bank stocks, which older readers will recall was the source of the problems at Anglo.

Both Spain and Italy need to tap the markets on a continuing basis. The yields they now face at ten years are about the level that persuaded Ireland to take a holiday from the market last September. Their yield curves are also beginning to flatten ominously, with shorter rates rising more quickly than mediums.   

The bank stress tests Mark II are due on Friday. This could be a long week.