Author: John McHale

In a series of informative comments across recent threads, Michael Hennigan has raised important questions relating to the reliability of the recorded growth in key macroeconomic aggregates, and also the employment performance of internationally traded sector in general and the foreign-sector in particular. (See here for a useful summary from his Finfacts website).  Although Michael watches these figures much more closely than I do, and so I hesitate to contradict him, I find it hard to share some of his concerns.  

First a point of agreement:  At roughly 100 percent of GDP, Irish exports are strongly influenced by the activities of multinationals operating in Ireland, and the numbers tell us little about value added and incomes in Ireland.   Where I have difficulty following Michael is in his concerns about the reliability of Irish GNP and GDP figures.   GNP excludes the profits of multinationals (and not just repatriated profits), and so should be immune from concerns over tax-driven transfer pricing.    GDP excludes imports (including intermediate imports and royalties).    Michael says the Irish exports are overstated by one third.   If he has a chance, he might explain this in more detail, and also how he sees it affecting measured GNP and GDP given the exclusions just noted. 

Michael also notes that employment in the foreign-owned sector has fallen from 166,000 in 2000 to 144,000 in 2011.   This fall is certainly very regrettable.   But it occurred during a massive bubble-driven, structural mal-adjustment of the economy.   Given the extent to which the bubble affected the allocation of resources, I am surprised the damage done to the traded sector was not much greater.  Part of the answer would appear to be the highly elastic labour supply response – notably through immigration – which allowed the construction and other non-internationally traded sectors to expand, while limiting the damage to the traded sector. 

I do share Michael’s concern over risks around the projected return to robust growth after 2013.  But my main concern is a prolonged “balance-sheet recession”—and not just in Ireland.    While Michael’s description of the nature of much multinational activity in Ireland seems accurate, I find it hard to share his concerns about its implications for measured Irish growth performance.   I am ready to be corrected. 

Michael Hennigan noted fairly enough that my previous post was a bit on the arcane side.   I’m afraid he will see this one as no better.  

I think it is worthwhile to take a step back and think about how ECB bond buying could have positive effect, and to think about the effectiveness of past and possible future bond-buying programmes in that light.   A useful starting point is to recognise that the willingness to pay for a bond with a given face value and coupon rate depends on the “risk free rate” and the perception of default risk.   If everyone agreed on the default risk, then the demand curve for bonds would be perfectly flat.   If a bond buying programme did not actually change the perception of default risk, then bond buying would have no effect on secondary market price and thus on yields.   (A useful way of thinking about official bond buying is that it shifts the market supply curve leftwards; if the market demand curve is horizontal, then there will be no change in price (and thus yields)).  

However, if there are varying perceptions of default risk, then – even if the bond buying programme itself does not change anyone’s perception of default risk – the programme will raise bond prices (and reduce yields), as the market moves up along a downward sloping demand curve.   (The differing perceptions of default risk is what makes the demand curve downward sloping, given the resulting variation in willingness to pay.)   My sense is that this is what broadly happened in the first phase of bond buying.  The weak commitment to the programme did little to change actual perceptions of default risk.   Thus, while purchases were somewhat effective in reducing yields, the positive impact was very limited, as ultimate default risks were left largely unchanged.  The programme ended up in failure.

It seems Mario Draghi is well aware of this, and he wants any future to operate quite differently.   The key is to provide a credible commitment to keep yields down and ensure that expectations of a “bad expectational equilibrium” do not take hold.  But there is understandable concern over moral hazard.   Although some European policy makers seem to have a difficult time giving up on market discipline (even after Deauville), I don’t see how we can pull out of the crisis unless the perception of default risk is kept low.  This leaves “conditionality” as the only feasible disciplining device.   But I don’t see how the ECB would be in a position to make a credible commitment to do what it takes unless this alternative disciplining device is in place, which explains the requirement that benefiting countries enter a programme.  

The goal should be to take risk of sovereign debt restructuring off the table as far as possible in any future programme.   (The example of Greece shows that the possibility of restructuring cannot be completely removed; and it did the credibility of the Trichet-led ECB no good to make ludicrous statements that restructuring was impossible.)  Mr. Draghi’s (vague) commitment to revisit ECB seniority can be viewed as backing up this approach, so that even in the low probability event that there is a restructuring, the losses would be shared with official creditors.  

(As an aside, I think that a major factor behind the fall in Irish yields is the that, even if there is need for a second programme, the risk of a debt restructuring being part of that programme has fallen significantly.)  

Overall, Mr. Draghi seems to moving in the right direction.   Let’s hope he can deliver.

Karl Whelan has a good post on the exaggerated fears of ECB insolvency, rightly pointing out that standard ideas of bank or non-bank-corporate insolvency do not transfer well to a central bank with the power to create liabilities at will.

But I think Karl’s post underplays the importance of potential redistribution effects of monetary policy within a monetary union.   (Although the ECB’s stress on price stability gets most attention, my sense is that the avoidance of redistributions between members plays at least as important a role in their thinking.)   One way of seeing this is to recognise that the amount of seigniorage-related revenues available for ultimate distribution to member governments is fixed by the inflation target (given real growth and other determinants of the change in money demand.)   Losses on asset purchases will lower these revenues. 

This also relates to discussions of design flaws in the euro, and especially the absence of effective bailout mechanisms.   The revealed fragility of creditworthiness within the monetary union shows the seriousness of this flaw.  But the “no-bailout-rule” was there to reduce the risk of redistributions, and without it many countries would not have signed up.   The revealed design flaw will have to be fixed if the euro is to survive.   Yet I think there is a better chance of effective negotiated change if legitimate concerns over redistributions are recognised.

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. 

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.