Market failures—part of our stock and trade—are pervasive in innovation-intensive industries.   The failures largely stem from externalities—both technological (e.g. knowledge spillovers) and market-mediated (e.g. the local availability of specialist input suppliers).   These externalities give rise to the system effects that are at the heart of the Taskforce’s report.     Shamelessly resorting to our own jargon, the elements of the innovation system are strategic complements: an increase in the level of one element (e.g. venture capital) increases the profitability and levels of other elements (e.g. private R&D) and vice versa.   This gives rise to positive feedback loops that can explain the clustering of innovation industries.    One unfortunate consequence it is very hard to do cost-benefit analysis of particular government policies, which goes a way to explaining our reticence and cynicism.  Just because it is hard does not mean these effects are unimportant, however.   And we may have to rely on theory and macro-based evidence in addition to more standard evaluations.   

Another reason that economists should not disengage from the debate is that government failures are pervasive in innovation policy.   While government policies can play a critical supporting role in building the innovation system, international evidence shows they get it wrong much more often than they get it right.   These failures are well documented by Josh Lerner in his recent Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed–and What to Do About It (Princeton University Press) [Economist article here]).  The evidence would suggest, for example, that government-directed angel funds are a bad idea.   On the other hand, policies that go with the grain of the market, such as government matches for international venture capital fund investments, stand a better chance of success.  Economics has a central role in indentifying policies that work.  

Paradoxically, the fear of government failure can sometimes lead to demands for self-defeating forms of accountability.    The provision of incentives for innovation often takes the form of a multi-task principal-agent problem.   Demands for accountability can lead to an excessive focus on the tasks most easily quantified.   Thus we get the innovation output of universities being measured by crazy indicators such as the number of patents, or the number of spin-outs, or even the number of PhDs.   Taking patents, we know that the distribution of value is fat-tailed—a large majority of patents are close to valueless.  A measure that simply counts is likely to be misleading and distorting.   In a different context, Declan Kieberd quotes Einstein in today’s Irish Times; the quote seems apt here also: “What counts can’t always be counted and what can be counted doesn’t always count”. 

Armed with our tools for studying both market and government failures, economists should be at the forefront of the innovation policy debate. 

Should a eurozone member ultimately find itself unable to consolidate its budgets or restore its competitiveness, this country should, as a last resort, exit the monetary union while being able to remain a member of the EU.

If you wanted to set up a system which maximised the probability of self-fulfilling market panics and speculative attacks, this sounds like a good way to go about it.

High impact firms and those with a poor track record should not expect to receive the benefit of the doubt from me or my staff when the best approach to addressing a risk is a point of contention between us. We will have an open and engaged dialogue with a firm’s senior management. But if we remain unconvinced by management’s plans we will be prepared to substitute our prudential judgement for their commercial one and say: Just do it.

This Nike approach to financial regulation could come as something of a shock to our banks.

I was critical of the composition of the taskforce when it was appointed but, rather than fire off knee-jerk criticisms, I’d like to take some time to read it before commenting further. However, as always, cogent opinions from our commenters are very welcome.

link here

Update: Thanks to Michael Hennigan for noting that the impressive Mr. Weber also gave a completely different speech to Financial Services Ireland on the same day, titled “Making the Financial System more Resilient – The Role of Capital Requirements.”  Link here.

These briefing papers are provided to MEPs on the committee prior to a meeting they will have with ECB President Trichet on March 22nd at which these and other issues will be discussed.

Summary: Asset booms and sectoral changes can distort traditional estimates of structural fiscal revenue, and could lead to serious fiscal policy errors. This paper extends the estimation of structural revenues to take account of asset prices and sectoral changes, and applies this to the case of Ireland, where a property bust has revealed a large hole in the public finances. It is shown that excluding these factors led to a substantial bias in the estimation of structural revenues, and the structural balance prior to the crisis was much larger than earlier estimated.

The first relates to the discount rate used to value cash flows when coming up with long-term economic value.  These had provided for an adjustment of 0.8 percent above the relevant government bond rate. This adjustment is now 1.7 percent.  This change will lower the value of the assets.

Government bond rates are, of course, lower now than they were last September. This is probably what the Minister was referring to when he said “There will, however, be a reduction in the interest rates used for loan discounting purposes” a comment widely (and now it seems incorrectly) reported as being related to the Commission’s recommendations. We see now that the Commission’s recommendations, taken on their own, will imply lower prices paid.

The other change I can spot relates to the (to me) mysterious “Standard Discount Rate”. The regulations for this used to be as follows.

The standard discount rate that NAMA shall apply in the calculation of the long-term economic value of all bank assets shall be 2.75 per cent to provide for enforcement costs, and 0.25 per cent to provide for due diligence costs.

The 2.75 percent is now 5.25 percent. From previous discussions, the prize for best answer as to what the standard discount rate was went to Frank Galton: NAMA LTEV = LTEV*(1-Standard Discount Rate). Assuming that’s correct, then this latest change would also imply lower prices. Anyone who understands the standard discount rate (or can see any other interesting changes) feel free to explain it to us.

One aspect of this story that I’m having some trouble understanding is why the IMF cannot be used to assist an EU member. The Irish Times Cantillon column explains the argument as follows. Current circumstances imply that:

The only possible lender of last resort is thus the International Monetary Fund, but an IMF intervention in a euro-zone economy would be a mortal blow to the credibility of the euro.

Ok, here’s a question. What does “mortal blow to the credibility of the euro” actually mean? And if it means something concrete (and bad) why does an IMF intervention produce this bad outcome while an EMF intervention does not? Answers on an electronic postcard …

To recall: the red lines show what happen when governments respond to a worldwide economic crisis with monetary and fiscal stimulus. The blue lines show what happens when governments stick to monetary and fiscal orthodoxy. All very purgative and morally satisying no doubt, except that it led directly to the election of Adolf Hitler (something that I have been meaning to blog about for a while, but now I have to prepare for class..)

For an individual country, ‘internal devaluation’ is the optimal strategy in our situation. (Optimal given our constraints that is — it is an incredibly lousy option relative to nominal devaluation, or being able to run a counter-cyclical fiscal policy.) But if everyone is doing the same thing, then it becomes collectively self-defeating.

This is a European problem, and requires European solutions designed to support demand and prevent continent-wide deflation.

Paul Krugman is alarmed here.

It is hard for anyone to disagree with many of the policy recommendations in the letter. An important point is  that many of these policies could be pursued simultaneously with the current strategy of stabilising the fiscal situation and  contributing to the process of real devaluation as a mechanism to improve competitiveness. As has been repeatedly pointed out on this blog, labour demand can be boosted both through outward shifts in the labour demand curve (through productivity improvements) and through reductions in wage costs (movement along the labour demand curve) and there is no direct conflict between these two strategies.

The letter assigns at least part of the responsibility for the depth and severity of the recession to current government policies.  Policy failures during the pre-crisis period (inadequate financial regulation and pro-cyclical fiscal policies) have certainly contributed to the severe contraction and it would have been much better if Ireland had accumulated sufficiently large surpluses during the boom years to provide the fiscal space required to engage in counter-cyclical fiscal interventions.  In addition, it is possible to debate the appropriate mix between current and capital spending within the current aggregate envelope and the optimal sequence for the required increases in the overall tax burden.

However, given the massive shock to the economy and the public finances, the over-riding imperative in setting fiscal policy has been to demonstrate a commitment to fiscal sustainability. If the government had not undertaken a sizeable fiscal adjustment, the spread on sovereign debt would surely be much higher than the current elevated level and the upward movement in interest rates (influencing the funding costs for the banking system as well as for the government) would have had an even more contractionary impact on the economy.

Conditional on the environment facing the country, the path of fiscal adjustment is more certain of returning growth to the economy than an aspirational alternative that seems to rely on investment-led growth to jointly solve the fiscal crisis and the economic crisis without having to resort to cuts in the level of public expenditure (beyond any savings from efficiency gains).  The international economic consensus highlights that  the optimal fiscal response to the crisis varies substantially across countries, with fiscal adjustment required for those countries that face a difficult funding situation. As such, it is perfectly consistent to advocate more expansionary fiscal policies for some countries while also supporting fiscal adjustment in Ireland.

Finally, the letter makes a number of recommendations for re-shaping longer-term economic policies. The debate about post-crisis policies is important and the coherent vision provided by this letter is a valuable contribution - but the first order of business is to safely emerge from the current crisis.

The wide-ranging guarantee of bank liabilities announced at the end of September 2008 runs out in little more than six months. Assuming that the banks have been recapitalised by then, the government can minimise subsequent risk of exchequer cost through getting out of the guarantee business as quickly as possible.

Bank resolution legislation – clarifying the power of the authorities to ensure that all providers of risk capital share quickly and appropriately the losses incurred by failed banks – is an important component in the state’s exit strategy from the banking collapse.

I believe the more pressing issue is to have a resolution regime in place for the period after the current guarantee expires and before existing subordinated bonds mature.  If the banks are insolvent, or at least incapable of reaching minimum capital adequacy requirements on their own, there should be a willingness to impose these losses on creditors, most likely as part of the debt-equity swap long advocated by Karl Whelan. 

While it may just be semantics, I think it is better if this is not viewed as temporary nationalisation, which raises the spectre of a (possibly long) period of political control.  There is a dangerous appetite for political control of lending.   Thus we get this in an otherwise sensible analysis by Alan Ruddock in the Sunday Independent:

If the Government’s new policy is to have any teeth it must be able to force the banks to do what they have not done for a long time, if ever: support the Irish economy. That will have to involve very close monitoring of margins and lending quantities, but without the political system becoming too involved in the day-to-day operations of the banks. In other words, effective regulation.

The real sin of NAMA may end up being one of omission rather than commission: it has distracted from putting in place the needed resolution regime.  I fear that a banking commission, though ultimately essential, might be another expensive distraction for the coming months.  The focus now should be on the joint tasks of ensuring losses are fairly borne by the providers of risk capital, recapitalising through debt-equity swaps and ensuring control of lending is kept as far as possible from politicians. 

The Irish sex ratio at birth was 1.058 in 2008. This is exactly the median for western European countries. Moreover, there has been virtually no change in the Irish ratio over the past fifty years – it was 1.0523 in 1960 and 1.0589 in 2000. This suggests that changes such as the increased availability of pre-natal scans and the rise in pregnancy terminations by Irish women since 1960 have not had any differential gender impact.

As The Economist points out, the sex ratio is an important indicator of the place and status of women in society and the economy. The normality and stability of the Irish ratio is therefore not without its significance.

There are three ways to inject new equity capital into the two surviving[1] banks: 1) the government directly purchases more equity shares from the banks, 2) the banks try to raise the equity from existing shareholders using a rights offering, or 3) the banks accept a big block acquisition of equity capital from a large foreign institution probably a foreign bank. The Central Bank and Department of Finance should be pushing hard on the banks to use method 3, since this method is in the best interest of the Irish taxpayer and Irish economy.

It is standard best practice to rescue ailing banks via arranged takeovers by strong banks. For example, in the USA the Federal Deposit Insurance Corporation and Federal Reserve have very well-honed procedures and can arrange these forced-marriages quickly and smoothly. In the current Irish situation there are several big advantages over the other two methods:

1. It brings harsh market discipline to the banks. If using method 1 instead, the banks become majority state-owned, and the political biases in government policy might infect bank strategies even more strongly than at present. This is a serious concern. For example, recent government banking policies (liability guarantee, Anglo Irish non-closure, NAMA business plan, property price information suppression) have been very generous toward Irish property developers, at great expense to Irish taxpayers and the Irish economy. A foreign bank would not have these political biases – perhaps it could even strong-arm the government into releasing a property price register and also force the government to stop working through NAMA to prevent property prices from dropping to a market-clearing equilibrium. Method 2, an attempted rights offering, would leave the banks very weak and essentially wards of the state, and hence many of the same concerns apply.

2. A foreign block acquisition would provide market validation of the equity price for the Irish banks. By opening up its books to a foreign acquirer, and then accepting a fair offer for some or all of the shares of the bank, the bank provides a true picture of the state of the bank, and by extension a valuation guide for other Irish banks and building societies.

3. The implicit cost of the government liability guarantee, for any bank in foreign ownership, would fall to near-zero. The liability guarantee would be buffered by the big foreign bank’s large asset base.

The drawback to a foreign takeover is that domestic shareholders (?) would lose control of either or both of the two main banks. I think that this is a price that the Irish public should accept. The banks gambled recklessly with their legacy and lost the bet. Domestic ownership of the banks matters very little in a very open economy like Ireland’s.