Beware of journalists bearing history lessons

Today’s Irish Times contains this gem from Stephen Collins:

Another issue that did not get serious traction in the talks was the simplistic call to “burn the bondholders” for which German chancellor Angela Merkel has to take a lot of responsibility.

The European Central Bank was adamantly opposed to the notion as any such move would threaten the financial stability of Europe. It is ironic that the zealots of the US Tea Party movement and many of those on the left in Ireland share a common belief in “burning bondholders” and damn the consequences.

The lesson of the Great Depression of the 1930s was that taking that kind of approach leads to widespread bank failures and national economic collapse which, in turn, threatens the democratic foundations on which our society is built.

Give me a break.

The bank failures of the 1930s were due to bank runs caused by excessively conservative monetary policies, and in particular by the determination of elites to stick with the gold standard well past its sell-by date. Burning bondholders had nothing to do with it.

Insofar as the 1930s involved debt restructuring (in Latin America, for example), this was part of the solution, not part of the problem — cf. the work by Eichengreen and Portes.

The lesson of the 1930s is that slavish adherence to economic orthodoxy can lead to disaster, and that sometimes you need a radical break with past policy mistakes in order to turn around expectations and prepare the way for recovery. FDR’s abandoning the gold standard was one such radical break; there were other radical breaks with the past that were much less benign, and that were directly caused by previous hyper-orthodoxy.

Finally abandoning the socialization of private losses would not just have made the Irish state more solvent, but would have clearly signalled a new beginning in Irish political and economic life. As things stand, it is hard to disagree with Mohamed El-Erian that the present deal is not the game-changer that Ireland needs.

Migration, the limits of internal devaluation, and the bailout

It is time to dust off old ways of thinking about the Irish economy that were useful in the past.

In the long run, migration sets a floor to Irish wages. It has been thus ever since the Famine of the 1840s, and I don’t believe that the Irish have become less mobile in the last 20 years. Now, a lot of Irish wages are still high by international standards, but eventually as ‘internal devaluation’ proceeds, and as peoples’ living standards are lowered as a result of tax hikes and cuts to public services, it seems inevitable that the ‘migration constraint’ will start to bind again.

Once this happens, then very roughly speaking the size of the Irish economy will be largely governed by relationships of the following sort:

w(1-t) + b + P = E

where w is the wage (which determines employment and output, for given levels of the capital stock and technology); t is the tax rate; b is the value to workers of the public services they receive; P is the premium we enjoy as a result of living in Ireland; and E is the living standard which we can enjoy overseas. If the left hand side of this equation falls too far below the right hand side, people will leave until equilibrium is re-established.

Once we hit this constraint, either because w falls, or t increases and b declines, adjustment in the economy will be more quantity-based and less price-based than it has been to date.

And it gets worse, since t and b depend inter alia on the levels of output and employment. There are fixed costs to running a state, and the debts we are now being saddled with are not population-dependent. You don’t have to be Paul Krugman to see the potential for some pretty nasty feedback loops here.

What can politicians do? The most obvious thing to do is to minimize the debt overhang facing this State, so that t is not higher, and b is not lower, than they otherwise would have to be. Less obviously, if politicians — not the existing ones, obviously, but an entirely new political class — can increase P, by providing people with a political project for national renewal that they can buy into, this might also help convince some people at the margin to stay at home. This is not just essential for our democracy, but for the economy as well.

Taking Stock

It is a day for taking stock after an extraordinary week.   On Wednesday, the Government unveiled its four-year plan for stabilising the debt ratio with about as much political acceptance as could be expected.   Yet by the end of the week the expected probability of default on sovereign debt implied by bond yields had increased, and that was despite the imminent announcement of the details of an international rescue package.    It was also a week in which those advocating sovereign default—on State guaranteed bank debt and State bonds—were advancing, while those arguing that creditworthiness could still be restored were in retreat.   I think it is worthwhile to reflect on the two broad views.  Continue reading “Taking Stock”

It was all the fault of foreigners

In the past week or so there have been plenty of attempts by the Dublin elite who have sleep-walked this country into catastrophe to blame others. For an example, see the quotations in this article. If Chancellor Merkel had kept her big mouth shut, the implication is, everything would have been alright.

This line of argument seems to imply that Ireland was simply facing a liquidity crisis — in which random events and loose lips can indeed sink ships of state. And, to be fair, there certainly was a liquidity crisis.

However, an awful lot of influential external observers believe that Ireland is also facing a solvency crisis, brought about by the suicidal bank guarantee of September 2008, and compounded by our lousy growth performance (10 successive quarters of falling real GNP, with more potentially to come). The Government could have chosen to listen to Morgan Kelly that evening, but it didn’t — after all, who would take such an irresponsible young person seriously! — and the rest is history. If it is a solvency crisis, then it was always going to come to this, as long as the Government tried to stand by that guarantee. Mrs Merkel may have been the trigger, but if she had stayed quiet there would, inevitably, have been some other trigger.

The really important point to make about what Mrs Merkel said is that she was right. There is indeed a limit to how much taxpayers are going to be willing to bail out bank creditors, and so there should be. If she, or the IMF, or any other external body, forces the sort of restructuring of bank debt that our own leaders have been so reluctant to contemplate, then ordinary Irish people will be very grateful to them. If the restructuring doesn’t happen this weekend or soon thereafter, then presumably it will be a major issue in the forthcoming general election campaign, and we will get an early test of whether Mrs Merkel’s political instincts are right.

Update: today’s FT editorial makes some very similar points.

Rehn Spokesperson on Bank Senior Debt

On Morning Ireland a few hours ago, Amadeu Altfaj Tardio, Spokesman for the European Commissioner Olli Rehn, was asked by RTE’s Rachael English (about 5.08 minutes in) whether the EU would countenance senior bond holders sharing the burden as part of the Irish bailout.

Possibly Amadeu didn’t quite understand the question (though he was asked it twice in pretty clear terms.) Anyway, my understanding of his response was that he could countenance this type of burden sharing. He said the issue “was under discussion” though it seems as though he meant this in the sense of a general Euro-area policy in this area was being discussed, rather than that he knew that this issue was being discussed in the current Irish bailout negotiations.

Further clarifications on this issue should probably be sought.

EFSF Charging 7%?

During the discussion of the bailout on Prime Time tonight, the prospect was raised (and not denied by Minister Batt O’Keefe) of the EFSF charging 7% to Ireland for its loans.

It may be worth taking at look at the calculations that I did on this issue a few weeks ago. I worked out the formula for the interest rate at the time as

Effective Interest Rate = 1.2*(3-year swap rate + Margin + Annualised Cost of Once-Off Service Fee)

which worked out at the time as

Effective Interest Rate = 1.2*(1.57 + 3.0 + .167) = 1.2*4.737 = 5.68.

The three-year swap rate is now 1.9%, which would give

Effective Interest Rate = 1.2*(1.9 + 3.0 + .167) = 1.2*4.737 = 6.08.

The government’s most recent projections show the debt-GDP ratio peaking at 106%. This is prior to the admission that large amounts of additional money will be borrowed to recapitalise the banking sector. Piling on an interest rate of even 6.1% onto the likely debt levels would greatly reduce the prospect of Ireland avoiding sovereign default. An interest rate of 7% would be grossly unacceptable.

Put simply, if these reports are true, the government needs to refuse any deal based on such a high interest rate. Indeed, unless the government feel compelled to play their role in a morality play in which Ireland is used as cautionary tale, they should refuse any deal featuring a rate higher than the 5% rate that Greece obtained.

Update: As commenter Tull points out, while we’re drawing down the money over three years, the relevant maturity for the interest rate would be length of time before we have to pay it back.  Plug in seven years, for example, and we’d get

Effective Interest Rate = 1.2*(2.67 + 3.0 + .5/7) = 1.2*4.737 = 6.88.

IMF: Structural Reforms in Ireland

The IMF has just released a new Staff Position Note Lifting Euro Area Growth: Priorities for Structural Reforms and Governance

[One of the co-authors is Ajai Chopra]

Its recommendations for Ireland are:

1. In relation to the labour market:

  • Introduce gradual decrease of benefits over time of unemployment spell and stricter job search requirements
  • Provide more resources to the unemployment agencies (FÁS) to provide efficient job search assistance to the growing number of unemployed
  • Review the level of minimum wage to make it consistent with the general fall in wages

2. In relation to improving competitiveness:

  • Reform planning and licensing systems in net work industries, so as to increase competition in sheltered services sectors
  • Focus public resources on high-priority projects in the knowledge-based economy

Bondholders and Restructuring

The completely nebulous nature of last night’s annoucements in relation to bank restructuring means we are no wiser today than yesterday about what is actually going to happen with our banks. However, the following statement from Michael Noonan (not a man given to reckless speculation, I would venture) is worth discussing:

Fine Gael finance spokesman Michael Noonan said there may be conflict between European officials and the International Monetary Fund the restructuring of Ireland’s banks.

Mr Noonan said the IMF may favour more burden sharing with bank bond holders than European officials as a condition of aiding Ireland.

As is this article by John McManus.

A Call for a Public Retraction from Garret Fitzgerald

In the last 2 years or more, serious academic economists such as Morgan Kelly, Karl Whelan and other contributors to this blog have been subject to a campaign of anti-intellectual abuse by the ‘leaders’ of public opinion in Ireland.  The ad hominem attacks on Brian Lucey were unforgiveable.  Some of these opinion formers (those who work in the financial services sector) may shortly be unemployed.  Those who remain should be shunned, certainly by academics.

However one name sticks out – former Taoiseach Garret Fitzgerald.  Let me make my personal position clear: I can think of almost no one in Irish public life whom I have admired more. Let us not also forget that he served as a faculty member of the economics department in UCD for part of his career.  Consequently, his “gratuitously condescending comments….. regarding the NAMA dissenters”, to quote Kevin O’Rourke earlier today, were particularly puzzling.

Garret, I know you have the dignity to restore your reputation.  Now do so.

Lenihan Admits Banks Couldn’t Be Saved by the State

On This Week on RTE Radio One, just now, Brian Lenihan has admitted that his banking policies failed in the sense that the banking problem proved too big for the state to solve on its own.

The audio is now available here. Here’s the exchange about the failure of banking policies:

Richard Crowley: Our strategy failed. Could you not admit that now?

Brian Lenihan:  Yes it did in the sense that the banks were too big a problem for the country. I accept that.

Richard Crowley:  And the steps you took were not enough to prevent it.

Brian Lenihan:  The steps could not, given the limited resources a small state has. Yes, I accept all that. But nobody has suggested they were the wrong steps.

The incredibly depressing thing about the banking meltdown is how predictable it all was. Click here for a post from a year ago that links to a presentation I gave to the Labour Party titled “The Banks After NAMA.” A few highlighted phrases:

“government argues that the NAMA loan transfers will fix our banks and get credit flowing. There are good reasons to believe that this is not the case”

“The banks have not developed a sustainable new funding model.”

“more losses to come: The severity of this recession will trigger big losses on mortgages, business loans, credit cards”

“major banks are seriously undercapitalised relative to the size of their balance sheets.”

“the ECB’s unlimited lending policy is likely to come to an end over the next year or so. What then?”

I guess we have an answer now to the last question.

BARCAP: An EU/IMF Programme Could End the Irish Crisis

Antonio Garcia Pascual and Piero Ghezzi explain how a combination of a bank restructuring/recapitalisation fund and a line of credit for the sovereign can stabilise the Irish situation in this report.

Note:  In relation to the discussion of the Goldman Sachs report (and presumably similar comments can be made about this report from Barclays Capital), it is certainly sensible to be aware of potential institutional biases. However, the individual economists working at these types of institutions are typically top quality (PhDs from top-level universities, strong academic publication records and/or experience in policy organisations) and, beyond any institutional pressures, have powerful individual career incentives to maintain a reputation for high-quality macroeconomic analysis.

Austerity and the IMF

In his recent Richard H. Sabot Lecture, Ken Rogoff addresses the question of whether the IMF is guilty of imposing excessive austerity as part of a bailout.  The paper is here.  A summary quote:

I will argue that the simplest and perhaps most cutting version of the IMF austerity charges is simply confused. IMF loans typically relieve austerity; they do not make it worse. IMF support helps a country engage in less procyclical budget contraction than it might have been forced to do otherwise. That said, the IMF’s judgments in calibrating programs involve a huge range of subjective decisions about politics, psychology, and economics, judgments that are difficult to get “right” consistently. Toward the end of my remarks, I will argue that in many respects, the greatest problem with IMF programs is not excessive austerity with debtors but excessive generosity toward creditors.

More on Corporation Tax

The FT carries an article which highlights that some (unnamed) officials elsewhere in Europe think that raising the corporate tax rate should be part of the deal. One quote

“They need lots of money and we note they have a corporation tax rate that is very low,” the official said. “Supply must follow demand.”

It may be helpful to reproduce the table I posted last week: the range of variation in  corporate tax revenues to GDP is not that large across the OECD (except for oil-rich Norway). Given the importance of a pro-growth plan and the downside risks to the export sector of varying this tax rate, it does not seem wise for the international debate to focus on this topic.

Corp Tax

Honohan Interview on IMF\EU Loans to Ireland

Patrick Honohan has given an interview to Morning Ireland (audio available here) that provides some more clarity as to what is going on in relation to Ireland borrowing from the IMF and EU.

Update: For those without access to audio, here‘s an almost-accurate transcript from the Guardian’s new Irish business blog (I doubt somehow if Ireland will be borrowing in the form of FDRs. Different kinds of dead presidents are likely to be involved.)