By John McHaleSaturday, December 4th, 2010
Many commentators have used the idea of “vicious cycles” or “feedback loops” to understand the virility of the financial and economic crisis. (A nice example is this influential piece from last year by Larry Summers on the American situation.)
This schematic attempts to capture some of the feedback loops operating between the Irish banks, public finances and growth. One way to think about it is to view all three as facing some nasty headwinds. For the real economy, growth is retarded by an impaired credit system, budgetary austerity and various multiplier/accelerator effects that intensify the recession. For the public finances, it is harder to stabilise in the face of costly of automatic stabilisers, bank bailout costs and a self-fulfilling loss of creditworthiness as the risk premium on Irish debt rises. And for the banks, they are strained by falling assets values, lost credibility of government guarantees and a slow motion run on wholesale deposits. Everything seems to feed negatively on everything else.
The adverse dynamics became overwhelming in recent months and international assistance has been required to prevent an effective collapse of the Irish economy. The “bailout” means that the Government has time to implement a phased deficit reduction rather than face a sudden stop of funding, and the banks have access to recapitalisation funds and continued large-scale funding from the ECB. This helps to ease some of the most virulent sources of negative feedback.
The question now is whether it will be enough. While in no way meaning to minimise the challenge, I think it is worth pointing out some potential sources of resilience in the system. On growth, there are encouraging signs that despite severe headwinds the real economy is holding up surprisingly well (see here). With capital spending 16 percent below profile, this is happening despite a fiscal adjustment this year that is not that much smaller than the €6 billion adjustment that the economy will have to bear next year.
On the banks, a key point of contention is the likely future deterioration in loans, and especially mortgages. Time will tell whether the resilience view of Elderfield/Honohan or the mass impairment view of Kelly/Matthews is correct.
On the public finances, the key resilience factor is the capacity of the political system to generate the necessary primary budget surplus over the four- to five-year timeframe. The coming months will be especially revealing on that score.