The Irish Economy

“Europe would not function any more if it changed course after every election.”

(Angela Merkel, quoted here, poo-pooing the notion that French voters might have any say over whether the next government ratifies this treaty or not.)

Words fail me, but they’re hardly necessary,

I’m sure all the presentations will be posted here at some point but I had promised readers that I would put up my slides on ELA and promissory notes from today’s conference, so here they are.

Via the IIEA blog, a new leaked draft of the proposed fiscal compact. Importantly for Ireland, the wording that balanced budget laws need to be “constitutional or equivalent” has been replaced with “preferably constitutional”.

The most recent Final Conference to Save the Euro ended in disarray when the UK refused to sign up to a proposed set of EU treaty changes. The UK’s veto was due to the inclusion of an EU-wide Tobin Tax on security transactions in the set of proposals. The justification for an international Tobin Tax is quite strong. Hypercompetitive securities markets with excessively-large trading volumes and hyper-fast price changes are a serious danger to global financial stability. A Tobin Tax would eliminate these dangerous trading excesses without impinging much on underlying market efficiency. On other hand, the UK government’s refusal to sign up to an EU-only Tobin Tax, imposed on the City of London while the US and Asian global financial centres remain outside the tax net, was an obvious and sensible policy decision for the UK.

After the proposed EU treaty changes were restricted to a coalition of the willing, the Irish government fretted that a Tobin Tax might particularly disadvantage the Irish financial services industry, given that the UK will be outside the tax net.

What should be Ireland’s policy stance toward an international Tobin Tax? Should Ireland do the right thing as a global citizen by supporting such a tax within the Eurozone, or should it protect its international financial services industry from UK (and non-EU) predation and therefore veto any such tax proposal? It would be much better for all concerned if the Tobin Tax could be imposed at a global rather than EU level.

Sometime in the future, May 6th 2010 might rank with August 9th 2007 as a “warning date” for a subsequent financial market disaster. Recall that starting on August 9th 2007, quant-trading hedge funds experienced an extremely turbulent, credit-market-related meltdown. Although the quant-trading markets calmed down after about two weeks, many analysts now recognize this as an early warning signal of the subsequent global credit crisis. In an interesting parallel, on May 6th 2010, high-frequency trading systems generated a “flash crash” of US equity markets, causing a 9% fall and 9% rise of the US stock market within a 20 minute period. Some individual stock prices went bananas; completed trades at crazy prices during this short “flash crash” period were annulled that evening by the NYSE board. Since the markets righted themselves within a day or two, many analysts have forgotten about this incident. But could this “flash crash” be an early warning sign of a subsequent “permo-crash”? High frequency trading (HFT), using entirely computerized systems to trade at hyper-second frequency, now constitutes 70% of US equity and equity-related (equity baskets, futures, options) trading volume, and 30% in the UK. If HFT generates a flash-crash at the end of the trading day, rather than mid-day as on May 6th, and something else goes wrong at the same time, it could lead to an enormous disaster.

Tobin originally proposed his tax for the foreign exchange market, which was the first financial market to have hyper-competitive trading costs. He saw that most of the trading volume in forex markets provided very little economic value. A small tax would have a big influence on trading volume, rendering purely speculative and potentially destabilizing trading strategies unprofitable, while having little or no impact on the real economic value of these markets. Tobin called it “throwing sand in the wheels” of securities market trading. Nowadays, Tobin’s “sand in the wheels” metaphor is widely misunderstood. Tobin was a World War Two naval officer and throwing sand in the wheels was an accepted way to improve machine performance in his day. For mid-twentieth century machinery a little sand in the wheels would slow down the mechanism (think of something like a navy ship’s water pumps) and make for more reliable performance with less chance of overheating. With modern precision engineering the notion of “sand in the wheels” as a repair method seems ridiculous, so commentators assume Tobin is advocating sabotage of securities markets. That was not what he meant – “sand in the wheels” is an old-fashioned procedure to slow down machinery so that performance improves, not a means of sabotage. Oddly, the tax is designed to generate minimum revenue – it relies on the elasticity of trading volume to net costs, and tries to drive out destabilizing short-term trading strategies while collecting minimal tax revenue.

Now, after decades of hard-fought liberalization, US and UK equity markets have the same hyper-competitive trading costs as forex markets. HFT has hijacked this and feeds off this market cost improvement (and by earning net profits from “normal” market traders) with trading systems that add little real efficiency improvement for markets. Eliminating their net profits with a small tax would do little harm, and make markets safer. The very bright computer scientists who run these HFT firms could go back to socially useful activities like designing better software.

There is another interesting parallel to the global credit crisis. US housing regulators worked for thirty years to increase access to owner-occupied housing for lower and middle income households and this was a big success. Then, they took that policy too far, and the policy was hijacked by self-interested actors in the US property lending and securities trading sectors. There was too much of a good thing in terms of the too-low-credit-quality US residential property lending market. The same applies now with securities market trading costs and trading access. Regulators have succeeded in driving out bad securities trading practices and greatly lowering trading costs, but this process has gone too far. It has been hijacked by HFT. I call this the Too Much of a Good Thing (TMGT) theory of regulatory capture.

During the credit bubble, Ireland enthusiastically joined the dumb-down contest to impose the minimal possible regulation on the financial services sector. Perhaps now Irish policy leaders could make amends by joining the push for a Tobin Tax.

How would a Tobin tax impact the competitive draw of Dublin for its brand of “off shore” financial services? Perhaps it would be the death knell for the Irish stock exchange since all trading volume might migrate to London. Ireland policymakers should encourage a global solution, bringing the US and UK in particular into the plan. Asian markets (which are not yet competitive for HFT) might be willing to cooperate as well, since there is no great cost for them.

A reader alerted me to this, which apparently is not a joke. For a horrible moment, I thought there was going to be ninety five theses but mercifully, the “people who count themselves friends of the Ifo Institute” limited themselves to sixteen.

Anyway, happy Christmas to one and all, even the friends of the Ifo Institute.

The latest attempt by the ECB to get a grip on the Eurozone crisis might work. It has the potential both to push sovereign market yields toward sustainable rates, and to block self-fulfilling institutional bank runs in which corporate deposits move to stronger Eurozone countries, draining weaker member banking systems of liquidity and credit.

Colm McCarthy was keen on a “reverse tap” in which the ECB enforces a maximum yield (minimum market price) on Italian/Spanish/etc sovereign bonds using its money-creation potential to back up this policy. The problem with his plan, in my view, was the lack of a surveillance mechanism to ensure the funded countries were continuing their needed restructuring. Germany would not accept that solution. My own preference was for the IMF to serve as conduit for sovereign funding via official IMF programs backed by ECB-funded bonds. Colm criticized this as an unnecessary intermediation by the IMF in a problem that needed to be solved by Europe.

The new ECB unlimited-three-year bank funding strategy uses the banks themselves as the monitor for sovereign discipline. It also provides direct bank liquidity so that the slow-motion institutional bank run phenomenon is less likely to lead to the negative feedback loop (corporate depositors distrust the PIIGS banks, PIIGS banks lose liquidity and restrict credit flow to their national economies, PIIGS national economies slow down due to shortage of credit, PIIGS banks suffer due to national economic slowdowns). Actually the “G” does not belong in this acronym anymore since it is a separate case. Perhaps PISI? Commercial banks in the PISI who lose corporate deposits to Germany or elsewhere can replace them with even cheaper funding from the ECB.

Might the new ECB strategy work?

A draft of the proposed Treaty has been released. I think we should be very very slow to look to put this to a referendum, if such is required (and it probably is).  Many things may happen in the meantime that could derail this particular process.

In the meantime, our leaders should stop making up exciting scenarios involving Ireland leaving the euro if a treaty is rejected. That Stephen Collins vehemently disagrees with this only strengthens my conviction on this point.

The latest collection of briefing papers for the European Parliament’s Monetary Dialogue with the ECB are available here (click on 19.12.2011). Five papers (including one by me) discusses issues related to ratings agencies, prompted by the recent package of regulations proposed by the European Commission.  Three other papers discuss the ongoing Euro crisis.

This could have been a useful contribution to the discussions about Target 2 if it was tweaked a bit.

For instance, the following slight re-wordings may have helped to inform rather than mislead:

Involuntary money acquisition is what happens when your spouse wins the lottery and gives you loads of money. At some point it dawns on you that you’re rich.

Or this

The bottom line: Germany’s Bundesbank—BuBa for short—has quietly, automatically received €495 billion to the European Central Bank via Target2.

Ok, no big deal. Financial journalists in getting things wrong shocker!

However, the piece does address a new aspect of the question that was not discussed in earlier discussions about the Target 2 balances. What happens if the Euro area breaks up?

Mr. Coy from Bloomberg is pretty sure it will be bad for Germany:

If the euro zone breaks into sorry little pieces, Germany could possibly lose its entire €495 billion claim. That’s more than $650 billion. It is 60 percent bigger than Germany’s annual federal budget.

But let’s take a closer look. Who is this “Germany”? Will the German residents who got their accounts credited as a result of the Target2-facilitated transfers out of Ireland now lose their money? No. There will be no losses to private citizens. Despite all this misleading stuff about “enforced lending”, German citizens will be very grateful that they managed to repatriate their money to German via Target2.

So who loses? Well, the Bundesbank has a Target2 credit from the ECB, an organisation that used to be considered sound and a good credit because they have the power to print money.

If the ECB ceases to exist and the Bundesbank wanted its balance sheet to still balance, it could simply replace the “Target2 credit” by writing itself a big check and sticking it in the vaults. Call it “Sondervermögen Ersetzen Vermögensverwaltung Früher als Target2 Kreditkarten Bekannte“ (“Special Fund Replacing Asset Formerly Known As Target2 Credit” – blame Google Translate!)  Just like that, the Bundesbank’s balance sheet is balanced again.

Now watch how many commenters will try to convince you that placing a piece of paper in an empty vault will unleash hyperinflation.

I wrote this post last night for the IIEA blog. I concluded it by discussing what I view as the likely upcoming referendum

Quoting myself(!):

It will be very important that other Eurozone member states be careful when discussing the problems faced by countries such as Ireland, for whom ratification of a new treaty will be politically complex.

For all the temptation to present such an agreement as a “yes or no” moment on euro membership (a temptation last seen with Mrs. Merkel’s “ya oder nein” moment) the truth is that there is no clearly defined way to expel a country from the single currency. Beyond the potential of a bullying approach back-firing with the Irish public, a focus on a referendum as a decision about euro membership risks triggering a massive bank run as depositors take flight to avoid the redenomination that is being threatened.

Needless to say, what happens today? Our own Minister for Finance comes out with the following:

FINANCE Minister Michael said today that any referendum here on the new EU deal would essentially be a vote on the country’s continued membership of the eurozone.

“It really comes down on this occasion to a very simple issue, do you want to continue in the euro or not,” Mr Noonan said in an interview with Bloomberg Television.

“Faced with that question, I think the Irish people will pass such a referendum.”

I think this is a very poor way for the government to approach this issue and I would hope they reconsider it.

The Irish public have a history of responding poorly to threats as a motivation for voting for EU treaties. And if Mr. Noonan is keen on triggering another disastrous bank run (this time also involving retail depositors) then he should keep talking this way and linking the probability of Ireland being in the euro with the latest polls on how likely the referendum is to pass.

The truth is that, whether people like it or not, the debate about this referendum will have many parallels with the Lisbon Treaty debate. It wasn’t true that voting no on Lisbon meant leaving the EU. But it was true that the rest of the EU could have decided to form some new agreement, something which would have required a complex legal and political process.

Similarly, there is simply is no expulsion route from the euro. If Ireland voted down the new intergovernmental treaty but the government wished us to stay in the euro, then there is nothing that could be done to eject Ireland from what is legally a fixed and irrevocable currency union.

It is possible for other countries to move on after an Irish No vote to set up their own currency union. However, this would require them to leave the euro, which would very likely involve them leaving the EU. Legally and economically, such an approach would be hugely difficult for the EU, certainly more difficult than going on to apply the Lisbon changes to some inner core EU.

So a “No” vote would likely leave the EU with a legal and political mess similar to that which occurred after the failure of the Lisbon vote in Ireland in 2008. From the point of view of the core EU countries, this is all very undesirable. They hardly want to admit that any country that doesn’t like the proposed treaty should go around asking for changes on an a la carte basis. If this were the case, then there probably would be no treaty at all (no bad thing, some might say).

But that’s where things stand and it wasn’t a situation schemed up by Irish politicians.

Government ministers should say there is simply no question of Ireland leaving the euro and that’s the end of it. Then they should enter treaty negotiations reminding everyone in Europe of the terrible nuisance that is their constitution and of the huge decline in the popularity of the EU in Ireland since Lisbon and Nice were voted down.

While I don’t necessarily want to endorse Fintan O’Toole’s language about causing trouble, the legal situation is what it is and the government need to make the most of a bad situation. (This issue was also discussed on Monday’s edition of The Frontline).

It’s time to argue for a better treaty and a better deal on the IBRC debt.

It’s not time to bully the public about signing up to whatever is put in front of them or face being booted out of the euro.