Goodbye to All That

I’m not a fan of the Ireland Inc line of chat. But the concept has more immediacy and policy relevance since the balance sheet of the main banks has been more or less socialised. Recent discussions about the BOP turn-around, fiscal stabilisation, the rising savings ratio, NAMA, (State purchase of bank assets, risks of over-payment), and about off-balance sheet financing wheezes to sustain construction activity can all usefully be thought about in the context of the national balance sheet.

In addition to fiscal stabilisation, bank re-construction and the restoration of competitiveness, the national balance sheet needs to be shrunken and de-leveraged. By 2007, we had created an economy with an emerging public finance crisis, iffy banks, weakened competitiveness and a balance sheet with too much debt supporting over-valued assets. The balance sheet was in any event too big for comfort, even had the assets (property, equities) turned out OK.

They did’nt, net worth declined sharply in line with asset prices, and credit markets turned nasty. The declining net worth supports a smaller balance sheet anyway, and the nasty credit markets suggest contraction even if net worth was unimpared. So the decline in private sector credit demand, rising savings rate and improving BOP are to be welcomed, and substitution of private with public borrowing to be mourned, in this view. The macroeconomic strategy is to avoid  anything that looks even remotely like a return to 2007. This was not a good place to be. 

The Canadians had a phrase, in the 1980s, for the national inferiority complex occasioned by the decline in the Can $ versus the real thing. They called it ‘parity nostalgia’. There is a mood beginning to emerge, in policy proposals from opposition parties, social partnership talks, lobby group suggestions and from some economists, that I am going to call ’07 Nostalgia’. Things were better back then – we had higher employment, (incuding jobs for graduates!), higher investment, easier credit. So lets have some job creation, off balance sheet spending on infrastructure, banks that can lend again etc etc. This is 07-Nostalgia.

In three or four years time, if we are lucky, we will have an economy which needs to look very different from 2007, the final year of the first credit-fuelled bubble in the State’s history. It should look like this: (i) Government debt ratios stabilised and sovereign credit spreads back to low levels; (ii) competing banks strong enough to lend (a little); (iii) a competitive economy producing more exports, less houses, and (iv) a smaller and less leveraged balance sheet. This economy will inevitably be smaller than 07 for a while, have lower employment, a smaller construction sector, smaller aggregate bank balance sheet, bigger Exchequer debt, lower public spending, higher tax rates and possibly BOP surplusses for a few years.

All policy wheezes emanating from the commentariat over the next few months should be smell-tested for 07 Nostalgia, and rejected at the merest whiff.  We have been there and it did’nt work.

Why Should Geithner’s Auctions Work?

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.

Deflation Once Again

The CPI has fallen 1.0% sa in February and 3.9% in the four months since the turn in October (versus 4.4% unadjusted). HICP is down 1.1% sa in the three months since its later turn in November. The HICP fall of 0.6% sa in February is its largest to date. The difference between the two is mainly mortgage interest – owner-occupied housing costs are excluded from the HICP.

Year-on-year carryover in the CPI (what the year’s avg for 09 would be versus 08 if there is no further change from Feb) is now -2.7%. At Budget time in October, the expectation was for about +2.5%, so a prospective gap has already opened up of over 5% against Budget-time expectations, even if there are no further CPI falls. The recent ECB cut would have been too late for the March CPI (taken on second Tuesday) but will impact April, as will electricity and gas price reductions. If there are excise duty increases on April 7th., they would be just in time to impact April figs also. It is difficult to know if the currency appreciation against sterling has passed through yet, and there could be some increased outlet substitution bias problems for the CSO to grapple with. Overall there could be some further monthly falls, but the 1%-per-month drop in the CPI can hardly continue for long.

For 5 marks: What would the Budget in October have contained had the Minister known what was going to happen to CPI inflation?

De Larosiere on Bank Regulation

On a first reading, there is an elephant in Jacques de Larosiere’s kitchen. The report recommends a new architecture for pan-European supervision, falling short of a single pan-European regulator as Kevin O’Rourke notes. It also recommends revisions to Basel II, without much in the way of specifics. The report has been welcomed by the Commission and is to be considered by EU Finance ministers next month.

The elephant is moral hazard. European governments have instituted wide-ranging guarantees of bank liabilities, amounting to de facto (and potentially free in some cases) unfunded deposit insurance for commercial banks. The report rattles on about the possibility of a limited and pre-funded deposit insurance scheme, with the option of national variations on a European template. But it seems to me that the genie is out of the bottle, and that, if and when business-as-usual returns, the public will not believe that there are deposit insurance limits. If there is a systemic crisis, Governments will be expected to step in. Even if there is just one distressed commercial bank, it is difficult to see how the clamour for retrospective liability guarantees can be resisted. These expectations could be with us for generations.

Clearly there are categories of near-banks (hedgies, prop-trading units) which could credibly (in the eyes of the public) be placed outside the pale, and denied guarantee. But how to prevent banks, believed to be guaranteed, from lending to these entities at inadequate rates, endowed with too-cheap funds from the public deposited on the basis of an assumed guarantee?

The net question is this. What are the implications for regulation and supervision of a European banking system in which liabilities of all the main commercial banks are perceived to be guaranteed?  Can it be less than Glass/Steagel, plus high capital and liquidity ratios, plus intensive supervision and risk monitoring beyond anything thus far contemplated?

Margaret Thatcher lamented, at the end of the Cold War, that nuclear weapons could not be de-invented. Can the perception of perpetual availability of retrospective and ‘costless’ bank liability guarantees be de-invented?

December Retail Sales imply Rising Household Savings?

The sa volume of retail sales peaked in Q4 2008. This morning’s release for December completes the 2008 picture. There were qoq falls from Q1 to Q4 of 1.8%, 3.3%, 1% and 2.2%. The Dec figure was 8% below Dec 2008.

The quarterly national accounts, available only to Q3 2008 anyway, do not give the income table, and we can only guess at the intra-year patterns. If consumption has followed retail sales volume, there must have been a sharp increase in the savings rate through 08. Household income cannot have fallen anything like 8%, and even in Q4 it is doubtful if the income decline was as much as the 2.2% quarterly fall in retail sales volume. The direct tax increases had not kicked in, and many enjoyed nominal pay rises from September as consumer prices began to fall, offsetting the income loss from employment contraction. Household income will possibly fall more rapidly in Q1 2009, since unemployment seems to be rising faster; direct tax hikes are kicking in; and there seems to be a pay-reduction round going on in the private sector. If the savings rate continues to rise, the implication could be dire retail volumes for a while yet.

Here’s a question: the figures coming out since year-end have been pretty poor overall, suggesting that activity is declining even faster than feared. Does this mean that the downturn could be shorter? Is it the case that there is a given (given by world trade volumes, real exchange rate and competitiveness) macro-correction of x% to be endured, but x does not get bigger just because the economy gets through it faster?