Category: Banking Crisis

Stimulating Investment

A striking feature of the recent Quarterly National Accounts  was the dramatic fall in real investment: a 30.6 percent decline between 2007:Q4 and 2008:Q4.   The growth in real GDP over the same period was -7.5 percent.   Real investment contributed -7.3 percentage points (pp) to this change based on a standard decomposition with 2007:Q4 expenditure shares as weights.   [The contributions of the other components were: consumption (-2.0 pp); government spending (+0.1 pp); inventory investment (-1.8 pp); and net exports (+3.5 pp).]   It is worth noting that this dramatic fall in investment spending was not confined to building and construction.   In its recent Quarterly Bulletin, the Central Bank reports that overall real investment fell by 32.5 percent in 2008 (year-over-year), with building and construction investment down 35.3 percent, and machinery and equipment investment down 23.0 percent. 

Of course, investment is well known to be a volatile component of GDP.   Even so, the large decline raises concerns both because of its role in driving output below potential and also its influence on the medium-term growth path of that potential.  It is worthwhile to consider, then, what policies might be used to support private investment spending. 

One contributing factor to the decline is the contraction in the supply of credit.  Indeed, one of the central motivations for policy interventions to strengthen the balance sheets of the banks is to increase their willingness and capacity to lend.  The Central Bank’s recent Bulletin does report a modest tightening of reported credit standards between 2008:Q3 and 2008:Q4.  But the explanation for the tightening of standards is likely to lie at least as much in the problems with the balance sheets of the borrowers as with the banks.   Moreover, the deterioration in business net worth, profitability and cash flow are likely to have significantly curbed the demand for credit, explaining part of the decline in credit aggregates.

We thus need to look beyond banking policy to policy actions that might strengthen the financial condition of the non-financial business sector.   In considering possible policy actions, it is worth keeping in mind the well-supported finding from investment research that cash flow is strongly related to investment spending – particularly for smaller, less creditworthy businesses.   This is explained by various agency problems that make it hard to raise funds from financial intermediaries – problems that become more intense as the balance sheets of borrowers and the banks become weaker.    

These findings suggest the importance of examining policies that improve business cash flow.  Given the beating that business profitability has taken, cuts in corporate tax rates or investment-related tax breaks would be unlikely to have a strong stimulative effects.  However, one policy that would directly improve the cash flow (and after-tax profitability) of almost all businesses is a temporary cut in employer PRSI rates for all workers.   (Fine Gael has proposed a cut for new hires.  But this would have a very limited impact on the underlying cash flow position of businesses.)   It is hard to think of another single policy with more potential to ease the pressure on investment, production, and employment. 

Hindsight on banking crises

While I would not claim to have been able to foresee the global financial meltdown, triggered by the unprecedented crisis of structured finance, a few of the national systemic crises in Europe, including our own, occurred more or less independently and had a more traditional character.

Could early warning packages, designed to alert regulators in developing countries to the possible emergence of a boom-bust systemic banking crisis, been of use in Europe? In particular could they have provided ammunition for those who were warning about property bubble excesses in Ireland? To explore this, I revisited some old work of my own.

In a 1997 paper, published before the East Asia crisis broke and based on a statistical analysis of worldwide banking crises before 1995, I suggested two simple and readily available systemic indicators as warning flags of a possibly unsustainable banking boom. These are: the loan aggregate-to-deposit ratio and the real growth in private credit. Reluctant to claim too much, I cautioned that these flags should only be thought of as crude preliminary indicators that might generate many false positives.

In a 2000 paper, I showed that these two indicators had both indeed been flashing simultaneously during 1994-96 for all five of the countries most affected by the East Asia crisis of 1997-98. Furthermore, on that occasion there were few false positives: the flags were both raised for only five other (non-crisis) countries out of 139 countries for which data was available.

Now, revisiting this simple two-flag approach using 2004-2006 data on thirty European and selected other high income countries, I find a striking confirmation of its apparent usefulness.

Indeed, of these 30 countries the banking systems of only three countries, namely Iceland, Ireland and Latvia, registered above average values for both flags. Of course these are the three countries which have subsequently experienced the most severe bank-related collapses in Europe.

The two indicators are plotted in the Figure — the straight lines are the mean of each variable. Note how only the three countries referred to are in the top right quadrant.

Iceland, whose banking system collapsed in spectacular manner in October 2008, is the clear outlier, followed by Latvia which is also struggling — with IMF assistance — since last December, to emerge from a bank-led collapse.

Ireland was firmly in the danger zone too on this 2004-2006 data. Maybe I should have taken my crude early-warning system more seriously!

The countries included are: Austria, Belgium, Bulgaria, Canada, Chile, Croatia, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Latvia, Lithuania, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Romania, Slovak Republic, Spain, Sweden, Switzerland and the United Kingdom. These represent all of the smaller EEA countries for which full data is available in IFS (Cyprus, Estonia, Malta, Poland and Slovenia missing), plus Canada, Israel and New Zealand.

A Fair and Efficient Plan for Fixing Our Banks

Here‘s an article I wrote for today’s Irish Times which outlines a plan for dealing with the problems at our two major banks.

The View from the Brokers

Davy, Goodbody and NCB have collaborated on this joint report on the Irish economy: you can download it here.

Sachs on the Geithner Plan

Jeff Sachs has a nice piece in the FT on the Geithner plan.  Sachs is against it and explains his objections with a very clear numerical example.  Of course, readers of this blog have seen this kind of thing here already but Sachs makes an additional useful point that hasn’t been discussed here.

It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

This point is important in an Irish context because our government is discussing its own plan to overpay for bad bank assets.  It is natural for media commentators to interpret stocks going up as good news as usually this corresponds to good news about the broader economy. However, in this case, it should be remembered that stocks are just a claim of a particular group of investors on a particular sequence of future dividend payments.

Bank stocks rising on news that the government is likely to adopt such a plan—and probably rising a lot more if the plan is implemented—should be interpreted as good news for bank shareholders, but not necessarily as good news for the taxpayer.  There are better ways to solve our banking problems and analysis along the lines of “the market is reacting positively to the plan” misleads the public into thinking that plans like this represent good public policy.