Here‘s me in today’s Irish Times arguing against the current bad bank and risk insurance proposals.
Tonight’s Questions and Answers featured a heated exchange between Fintan O’Toole and Martin Cullen about whether the government knew how the pension levy was going to work when it was introduced. O’Toole has framed this question as being about whether the levy was applied to gross income or to net income. In his original article about this, he had asked
Is the levy a percentage of a worker’s entire income, or of that income after tax and PRSI? The answer to this question is crucial.
The article went on to heavily criticise the Taoiseach for asserting that the levy was applied to gross income and argued that this is not the case, a criticism that was repeated on Q&A.
Let me attempt to cut through the Gordian knot here and explain why both O’Toole and the Taoiseach are sure they are correct.
Today’s Irish Times reports that the government has hired Peter Bacon
to assess the possibility of creating a “bad bank” or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending.
I know I’m at risk of sounding like a broken record on this topic but, given its importance, I’ll add my latest two cents on this. I’m not in favour of either this form of “bad bank” or a risk insurance scheme.
Writing in today’s Sunday Times about the government’s €7 billion re-capitalisation of AIB and BOI, Damien Kiberd says “The money invested will almost certainly be recovered and, in the interim, it will pay the state an annual interest rate of 8%. This will bring the exchequer €560m a year”. Later in the article, Kiberd points to this €560m as one of the key measures that will help to improve the public finances. This idea that the money is a sound investment of taxpayer money has also been raised in recent days by the Minister for Finance and by Brian Goggin, CEO of Bank of Ireland. Despite this, I was a little surprised to see a high profile journalist endorse this position so strongly.
The scenario outlined by Kiberd is, of course, one possible outcome. But one can think of others. For instance, even if these banks remain in private ownership, they may not be able to pay back the government’s preference share investment in the five-year time frame envisaged and we can hardly be confident that a profit would be made from the options to convert the preference shares into ordinary shares at the strike prices agreed in the statement. More worryingly, if the banks need further recapitalisation or end up being nationalised, there would be little reason at that point to expect to see all of the original investment back.
In relation the “guaranteed 8% return”, there will doubtless be a transfer of €560m per year from these banks to the government. However, to the extent that these transfers further diminish the banks’ equity capital, then any future government injections of capital could be seen as just giving this money straight back so that, on net, the taxpayer doesn’t really benefit from this interest. And, of course, if the banks are nationalised, then these interest payments will just be transfers from one branch of the public sector to another.
Just to be clear, I am not saying that the rosy scenario can’t happen. I don’t claim to know the full extent of bad loans at these banks, so I’m not putting forward a judgement here on the need for (or likely extent of) future capital injections. Still, I’d be interested to know what our band of expert contributors and commentators think about the likely return on the government’s recapitalisation investments.
Here are the latest comments from the Minister for Finance on the “bad bank” idea. (And just to be clear, commenters, the bad bank proposal as currently understood in policy circles means governments overpaying for bad assets – a bad idea – and not the process of maximizing the sales value of these assets after banks have been nationalized – a good idea if nationalisation is indeed required.)
The headline “Lenihan says Government will consider setting up ‘bad bank’” confirms what anyone who watches RTE will already know (and what anyone who reads this blog will know I’m not very happy about). However, the piece starts out promisingly. “We can’t be jump-led by markets and market expectations into solutions that suit the banks rather than the people,” said Minister for finance Brian Lenihan last night, who noted banks were using the media to try to force politicians to adopt these types of state rescue plans. Well said Minister! Couldn’t have put it better myself.
And then some more good stuff: “Some of the proposals that have been advanced today such as risk insurance seem to involve a payment of a definite premium to the taxpayer in return for the assumption of an indefinite risk. And that is not something that any government could commit itself to,” said Mr Lenihan. That’s the spirit!
But then things get a bit murky: He said one of the difficulties with creating a scheme to deal with toxic assets was that it would add to the exposure of the state in relation to its sovereign debt. But he said it could be argued that if the Government had enough information on toxic assets – and Ireland was a small enough country to do this – and it could eliminate the risk then it would improve the risk posed by the existing Government bank guarantee scheme. “We are at a great advantage that many of the larger (European) states have very extensive loan books and it is very difficult for them to do the type of comprehensive trawl through their banking system that we have been able to do,” said Mr Lenihan, who noted that a lot of the toxic assets held by European banks related to commercial paper, which was much harder to value than the property-based debts held by Irish banks.
This sounds a bit like grasping defeat from the jaws of victory, the minister bending over backwards to figure out why the current-vintage bad bank proposal — while generally a bad idea — might actually be a good idea here.
I’m not exactly sure what the Minister is driving at here. But I will point out that the most coherent argument put forward in comments yesterday in favour of bad banks rather than just re-capitalisation (from Mick Costigan) involved the Knightian uncertainty provoked by toxic assets. Because people don’t know the distribution of losses, even a big re-capitalisation could still leave uncertainty about the potential for even bigger losses and thus doesn’t deliver confidence in the banking system.
This is an interesting argument though I don’t think it’s relevant to the Irish case. Firstly, there has to some figure for a large enough re-capitalisation (for instance, the full value of the bad assets) that gets rid of any Knightian uncertainty concerns. Secondly, our toxic assets aren’t rocket science CDO-squareds built by physicists which can’t be valued because nobody understands them. They’re bad loans to builders and we can go about making a reasonable guess at what they’re worth today. Indeed, the minister seems to be making exactly this point. So, as far as I can see, the Minister’s arguments seem to further point against the need for a bad bank scheme.
Last night’s RTE news was full of breathless commentary from Brussels and Montrose to the effect that governments needed to do more than just re-capitalise the banks. From Brussels, Sean Whelan excitedly talked about “toxic assets” and how it was going to be necessary to “buy the toxic assets at a steep discount, leaving the banks to continue with the viable parts of their business. Simply re-capitalising the banks isn’t seen as enough.” Back in Montrose, David Murphy authoritatively informed us that “In terms of doing something else in addition to re-capitalisation, they have an option of setting up a bad bank or, for instance, insuring the banks against the some of the bad loans that are coming down the track. But it’s pretty clear that the re-capitalisation on its own won’t be enough. And if they do something that isn’t enough, the markets won’t like it one little bit and Ireland will be punished for that.”
Despite the confident tones in which this expert analysis was delivered, as far as I can see it doesn’t make any sense.
There is no logical distinction between the issue of undercapitalisation and the problems created by so-called toxic assets. Banks could get rid of all their toxic assets in an instant if they just wrote them down to zero. But then they would be undercapitalised—and that’s the problem with toxic assets. What appears to be going on is that the various re-capitalisation programs around the world have not managed to offset the likely losses from bad loans. However, this is a problem with the size of the re-capitalisation programs, not their nature. There is no logical argument for now augmenting these programs with a scheme to systematically overpay for impaired assets. (Sean Whelan may think the proposal is for buying assets “at a steep discount” but that discount is relative to what they were originally worth, not what they are worth now.)
What appears to be going on is that neither banks or governments want to inject more government equity capital because going any further than we are now requires effectively admitting that the banks need to be nationalised. Government concerns about nationalising banks are well-founded but it seems that, in many cases, we are well beyond that point. If the banks can’t find private equity to re-capitalise them and government is willing to do so, then that’s where we should end up.
As a final point, it’s worth noting that despite the constant commentary about toxic assets and all the problems created by the evils of structured finance (CDO-squared and all that), this stuff is essentially irrelevant to the Irish banks. Their toxic assets are largely plain old loans to bankrupt developers and rocket science isn’t required to come up with a guess at the size of the loan losses. As Colm McCarthy has joked “We didn’t import any toxic assets, we grew our own.”
As usual, I have the sneaking feeling that I’m missing something. Perhaps our team of commenting pundits can explain to me what I’ve got wrong.
I’ve written here before about my puzzlement over the widespread international enthusiasm for “bad bank” proposals and I haven’t changed my mind since.
A more attractive proposal, which is getting less attention, is the idea of establishing new banks. It could be argued that this directly addresses the problems being created by the weak capitalization of the international banking system, without the extreme moral hazard problem associated with TARP-style over-paying for bad assets. The financial intermediation function performed by banks is crucial to the efficient functioning of the economy and, for a number of reasons, undercapitalized banks do not perform this function well. Understanding this, the approach of govenments everywhere has been to use taxpayers money to prop up undercapitalized banks. But while banks play a crucial role that doesn’t mean that we necessarily need the current set of banks to perform this role.
Kevin already posted a link to Willem Buiter proposing something like this but the idea is now being given wider prominence. Here for instance is a nice clearly-written piece from today’s Wall Street Journal by Stanford’s Paul Romer. An important benefit of this type of plan, as Romer notes, is that it seems more likely to attract additional private sector equity capital relative to the various plans to attract new investors for existing banks with failed management and murky balance sheets. Indeed, I first read about the idea of new banks in this 2009 predictions piece from celebrity uber-bear bank analyst Meredith Whitney and she was focusing purely on the private sector opportunities. She said: “I think you’ll see more new banks created. We’ve already seen more applications. And it’s a great idea: You start with a clean balance sheet and make loans today with today’s information. Plus, right now you’ve got a yield curve that’s good for lending.”
Skeptics could point out that these new banks will lack the branch network or knowledge capital of existing banks. However, branch networks could be purchased pretty cheaply these days and the newly-minted banks could be attractive places for those bankers with good track records to work. Perhaps the best argument against this idea is the time lags involved in getting new banks set up. But the problems in the international banking system seem likely to be with us for some time so useful long-term solutions may be called for.
No doubt I’m being wide-eyed and innocent here. Perhaps our trusty band of loyal commenters can give me a word to the wise.
Reading my Sunday newspapers for insights on the economic crisis, I came across the following from Damien Kiberd in the Sunday Times: “Two hundred economists gathered at UCD last week and all we heard from them were suggestions for more taxes: the reintroduction of domestic rates and third-level fees, taxes on child benefit, carbon taxes, taxes on social welfare, sucking the low-paid back into the tax net and higher excise duties. This is exactly what we did in the 1980s, when Ireland nearly went bankrupt.”
What a pity I missed that conference. Now I did attend an event on Monday at the Royal College of Physicians (organised by UCD and the Dublin Economics Workshop) and funnily enough that event had about two hundred people at it also. But there the similarities end. Participants at the conference I went to focused heavily on the need to cut public sector pay and of the range of tax measures mentioned by Kiberd, only one (reintroducing rates) was discussed. It’s rather strange of UCD to organise two different conferences on the same topic in the same week, but then that’s economists for you.
A number of comments on Kevin’s link to Buiter’s discussion of bank nationalisation have brought up the idea of a “bad bank” that can be used to take over non-performing assets. I think this issue is important enough to hoist out of the comments and onto the front page! It should be noted that Buiter is discussing this idea in the context of a fully nationalised British banking system. The “bad bank” idea has an “economies of scale” advantage in that case. so that all bad loans can be grouped together and dealt with by a team specialising in getting the best long-run return for the government from working out bad loans.
Outside the context of full nationalisation, I’m not sure I understand the “bad bank” idea or why it has caught on in the Irish media over the last day or two. I’ve been puzzling over this the last few days and then found a post by Paul Krugman that expressed my puzzlement far better than I could. In a post entitled bad bank bafflement (good post title!), Krugman says: “The idea of setting up a “bad bank” or “aggregator bank” to take over the financial system’s troubled assets seems to be gaining steam. So let me go on record as saying that I don’t understand the proposal. It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.”
In the Irish case, perhaps someone could explain to me how the bad bank proposal gets at this question. What price would the Irish government pay to struggling banks for their underperforming loan portfolios? Why should the government pay a price above current market value rather than, for instance, provide additional capital to cover the implicit losses and thus increase the government’s equity share?
As Krugman notes, in the US case, the answer to these questions appears to be that Bernanke believes the market is systematically underpricing a wide range of mortgage-backed securities and that the US government may break even (or perhaps profit) from buying them at above market rates and selling them later or holding to maturity. Whether Bernanke is right or not is open to question. But is there any reason to think a similar logic applies to Irish commercial property loans?
In my discussion at Monday’s conference (slides here), I raised the question of where Ireland’s tax burden was going to settle down once the public finances have been stabilized. The Addendum to the Stability Report published last week by the Department of Finance shows how the Gross Budget Balance can be brought back to a deficit of 2.5% by 2013 through an adjustment process in which the revenue share of GDP stays roughly stable so that almost all of the adjustment occurs on the Revenue side. The document itself does not comment on the composition of the adjustment described in this table, so perhaps this isn’t an actual plan but instead an illustrative example. Still, it’s worth starting with as a baseline for discussing where we are heading.
I noted on Monday that the plan projects a government revenue share of GDP of 34% in 2013 and that this is well below the equivalent share for EU15 countries, which has been stable at about 45% for a number of years. A number of observers at the conference questioned this calculation on the grounds that the calculation should be done relative to GNP. In particular, since GDP has been about 17% higher than GNP in recent years, one might want to adjust the tax share upwards by this amount. Doing so would give a figure for 2013 of about 41.5%. This is still a reasonable amount lower than the EU15 average but not nearly as much as the figures I quoted
However, I do not view this higher GNP-based figure as a useful one, for two reasons.
First, I believe that GDP rather than GNP should be viewed as the correct tax base when making calculations of this sort. GDP represents all the income generated in this country and, technically, all of it is available to be taxed by the Irish government at whatever rate it chooses. Of course, profit income generated by multinational corporations is likely to move elsewhere if we tax it at a sufficiently high rate but this is an issue faced by all governments, not just our own.
Second, if one is going to exclude the substantial factor income repatriated abroad (€28 billion in 2007) from the tax base it is not consistent to then include the taxes earned on this income in the measure of the tax burden. Assuming that the €28 billion figure represents corporate profits repatriated after paying the 12.5% corporate tax rate, one comes up with a figure of €4.1 billion in taxes paid by multinationals on repatriated profits. Excluding tax payments of this magnitude would give a 2013 (adjusted) tax share of GNP of 39%. So, even if one agreed with the idea of GNP as the tax base, an internally-consistent calculation of the Irish tax burden would still leave it well below the European average.
The broader and more important point here is that we need a wider debate about the shape of future fiscal adjustment than the one currently taking place, which focuses almost without exception on the need to reduce public sector pay.
The government has published a stability program update with new projections for the economy and for the budgetary situation. Projections are provided for the general government balance under current policies as well as under a multi-year adjustment plan.
The government now project declines in GDP of 4% in 2009 and 0.9% in 2010 and unemployment is projected to average 9.2% in 2009 and 10.5% in 2010. Without changes in policy, the general government balance is projected to be in deficit to the tune of 11%-12% of GDP every year out to 2013.
The govenment has decided to address the fiscal situation gradually over the next five years. The report states: “Restoring sustainability to the public finances can only realistically involve a period of adjustment of up to five years. Taking action over a shorter period of time, given the scale of the emerging position, would impose substantial economic and social costs and would not be sensible or appropriate.”
An adjustment of €2 billion is proposed for this year, still leaving a budget deficit of 9.5%. Subsequent adjustments of €4 billion in 2010 and 2011, €3.5 billion in 2012 and €3 billion in 2013 will gradually reduce the deficit over time to 2.5% in 2013.
No details are provided as to how these adjustments will be made. Worth noting, however, is that the adjustments total €16.5 billion. Given that the total bill for public sector pay and pensions is currently about €20 billion, it should be clear that despite the regular media focus on public sector pay cuts, restoring fiscal balance will require many other adjustments.
With a return to growth for the Irish economy heavily dependent on economic recovery in the world’s major economies, we must hope that the monetary policy actions being taken by the Fed and other leading central banks will be successful. Unfortunately, it’s a bit hard to judge what’s going on at the moment, particularly at the Fed.
I’m teaching a module at UCD this semester on central banking. I last taught the course in Autumn 2007 but already I’m going to have to rip up many of my old lecture notes, so dramatic have been the changes in monetary policy procedures, most notably at the Fed.
There have been a number of profound changes at the Fed, including a move away from targeting the Federal Funds rate and towards paying interest on reserves. But the most notable change has been the massive expansion in the size of the Fed’s balance sheet. The most useful summary of this development that I have found is this recent post by Jim Hamilton. Commenting on the huge expansion in the Fed’s balance sheet, Hamilton notes “The bottom line is that Bernanke has made a gamble with something approaching 2 trillion.”
Media coverage of the current Irish recession has popularized two ideas. The first is that the recession came about very suddenly. The second is that forecasts (such as the ESRI’s prediction of GNP growth of -4.6% for 2009 compared with -2.6% for 2008) imply that economic performance this year is likely to be far worse than last year. It turns out, however, that neither of these ideas are correct. The source of the misconception, in both cases, turns out to be the lack of use of the CSO’s quarterly national accounts (QNAs) in popular discussions of the Irish economy.
Take the first idea — that the recession occurred quite suddenly. The swing from GNP growth of 4.1% in 2007 to a projected decline in GNP of 2.6% in 2008 has been widely cited to illustrate a violent switch from excellent economic performance in 2007 to a slump in 2008. However, the truth is more subtle. These figures for economic growth are the “annual” growth rate, defined as the percentage difference between the average level of output in a year and the average level of output in the previous year. However, this calculation doesn’t always give an accurate indication of economic performance during a year because it is heavily influenced by what are known as “base effects”. To give an example of what this means, consider a case in which GNP expands rapidly one year and then stays constant throughout the next year. We might intuitively view the second year as one in which there was no growth. However, the “annual” growth rate will appear to be quite positive because the average level of GNP in the second year is higher than its average level in the previous year.
A closer look at the quarterly data shows a gradual slide into the current recession. The QNAs show seasonally adjusted real GNP alternated between expansions and declines from 2007:Q1 onwards. GNP turns out to have peaked in 2007:Q3 and the graph below clearly shows the economy was essentially flat over the period from 2007:Q1 to 2008:Q1 before a more pronounced recession set in during 2008:Q2. So, far from being sudden, the quarterly data show the economy stalling for about a year before the public realized a recession was upon us. (My UCD colleague Colm McCarthy made this point in his paper with Rossa White presented at the DEW in Kenmare).
Now consider the second idea, that a swing from -2.6% growth last year to -4.6% this year implies that things will be getting much worse. Again it turns out that this swing is completely due to the dreaded base effects. The ESRI’s figure of -2.6% growth for 2008 is consistent with a 1% decline in seasonally adjusted GNP in 2008:Q4. Combined with the declines from earlier in the year, the implied level of GNP at the end of 2008 is below the average for 2008 as a whole. So suppose, for example, that GNP managed to remain flat at this level for the whole year (a highly unlikely achievement). In this case, the average-over-average calculation for GNP growth for 2009 would give -2.1%. A dramatic turnaround from sharp contraction to flattening out would not be picked up by this measure.
Against the background of a severe worsening of the global economy and serious domestic fiscal problems, perhaps a better starting point is the observation that the year after 2008:Q3 is unlikely to be better than the previous year. GNP declined 4.8% over the year ending in 2008:Q3. Projecting this average decline of -1.2% per quarter through 2009:Q4, gives a figure for annual (average over average) GNP growth for 2009 of -5.1%.
These calculations show that, rather than a severe worsening, forecasts such as the ESRI’s projection of -4.6% for 2009 actually represent a slight improvement relative to the economic performance seen in the year ending in 2008:Q3.
My point here is not to question the ESRI’s forecast, which may turn out to be a good one, but to argue that economists and media commentators should make more use of the QNA figures when discussing the performance of the Irish economy.
One small change that could be made is to switch from discussing the average-over-average figure for output growth to instead discussing Q4-over-Q4 figures, which reflect the level of output at the end of the year relative to the start of the year. From my time working at the Federal Reserve Board, I know that this is the measure of growth that the Fed staff uses when describing its forecasts to the FOMC. In the above example of flat Irish GNP this year, this Q4-over-Q4 figure would show the economy improving from -4.7% in 2008 to 0% in 2009 rather than the marginal improvement cited above of going from -2.6% to -2.1%.
A caveat to this suggestion, however, relates to the use of GDP and GNP figures for projecting tax revenues. Because Ireland’s tax year corresponds to the calendar year, the year-average level of output is the appropriate figure for budget calculations. The calculations above show how far we are now from the projections underlying October’s budget. Taking the ESRI’s figure for 2008, achieving the budget’s projection of a 1% (average over average) decline in GNP in 2009 would require GNP to actually grow at a 2% annual average rate throughout 2009.