Morgan Kelly provides a critique of the re-capitalisation of Anglo-Irish Bank in today’s Irish Times: you can read it here.
There are so many fronts in the Armageddon in which the Irish economy is now engaged that some have received less attention than they deserve. The pensions’ crisis is an example. As most of the contributors to this Blog can look forwarding to drawing public service pensions – or like are already doing so – they might not be personally too concerned about the situation facing members of defined benefits schemes that have to rely on employer and employee contributions to meet their liabilities.
The collapse of equity prices has devastated the asset side of pension schemes’ balance sheets. In line with the conventional belief in a long-run “equity premium”, most schemes had between two thirds and three quarters of their assets in equities a few years ago. To make matters worse, the “home bias” of most Irish schemes led to an overconcentration in Irish equities, whose recent performance has been among the worst in the world. As a result, over the last eighteen months the assets of typical Irish pension funds have declined up to forty per cent. All the gains of the bull market of the 1990s have been erased, and in many cases asset values are back to where they were ten years ago but liabilities have continued to grow. Ominously, the annual average return to diversified portfolios over the past ten years has been less than the annual rate of inflation.
To this equity shock should be added a “longevity shock” –the good news on the demographic front has added more years to life expectancy over the past ten years than over the previous twenty and Ireland in particular has been enjoying a catch up with the most advanced countries on this front. Actuaries have to take account of the impact of this on pension schemes’ liabilities. About two years have been added to life expectancy at age 65 since the start of the century – equal to an increase of about twenty per cent in the life span of a pensioner.
And if this were not enough, there is the prospect of lower term “risk free” interest and annuity rates, which will inflate the present value of pension fund liabilities.
So there has been a perfect storm in this area too.
The legislation governing defined benefits schemes stipulates that pensioners have a priority claim on the scheme’s assets. Contributing members take second place in the queue. As a result, the developments outlined above have devastating implications for contributing members.
To give a very simplified example, consider a scheme that roughly balanced its assets and liabilities at €1 billion in early 2007. The scheme was mature in the sense that roughly half of its liabilities were in respect of pensioners.
Total €1 billion
To contributing members
Focussing exclusively on the decline in asset values – leaving aside the impact of increased longevity and falling interest rates – the situation at end-2008 would be:
Total €0.6 billion
To contributing members
The priority claim of pensioners on the assets will absorb €0.5 billion, leaving a residual of only €0.1 billion to cover the entitlements of contributing members. This represents only 20 per cent of their accrued benefits.
Long-serving members of a scheme like this should be very worried indeed. Their plight is a time bomb ticking away that has been somewhat ignored in light of all the other economic concerns we are facing. While there are as yet no precise estimates of the size of the aggregate deficit in these schemes, the total certainly exceeds the amounts being used to recapitalise the banking system.
What can be done? If pension schemes fail to meet a statutory minimum funding standard (MFS) each year, they must prepare a funding proposal to employers and members that will address the deficit over a medium term horizon. In the course of 2009 the Pensions Board will be receiving a steady flow of reports from schemes that do not meet the MFS and hence are technically insolvent. Short of a sustained and massive stock market recovery in the New Year, the scale of the contributions increases that would be required to redress the deficits is enormous and unlikely to be acceptable to hard-pressed employers and employees. This raises the spectre of large scale closures of defined benefits schemes, which would have serious social repercussions.
The issue of the potential inequity in the treatment of contributing members relative to pensioners will come to the fore as schemes are being wound up. It is hardly acceptable that someone with twenty or thirty years’ membership of a scheme should be entitled to a mere fraction of what they believed they had accumulated as pension entitlements.
Happy Christmas and a better 2009!
The CSO recently published its advance estimate for output, input and income in agriculture. Despite world prices for food hitting record highs in the early part of this year, the CSO estimates that GVA at basic prices fell by 17 per cent and that the operating surplus generated in the sector fell by 13 per cent in 2008.
The main reason is that, although agricultural output prices have risen by 20 per cent since the beginning of 2007, input prices driven by higher energy prices have risen even faster. As a result, Irish farmers have experienced a sharp deterioration in their terms of trade from its recent peak in September 2007. Output prices relative to input prices fell by 20 per cent between September 2007 and October 2008.
Gross value added at basic prices in primary agriculture is estimated to amount to €1,579.6 million in 2008. When interest on borrowing, wages to farm workers, land rental payments and capital depreciation are netted out, the amount left to remunerate farmers for their own labour, land and capital input is the princely sum of … -€186 million! (if you want to do the calculation yourselves, the raw data is provided in the CSO release).
Fortunately, farmers don’t depend on the market for their income (even the supported EU market in which , thanks to the Common Agricultural Policy, they can sell beef and dairy products for up to 75 per cent higher than third country competitors). Thanks to direct payments (which amounted to €1,995 million last year and will top the €2 billion mark this year because of the introduction of a new Suckler Cow Welfare Scheme), farm incomes will remain in positive territory. While some of these payments reflect the role of farming in producing valued public goods, their distribution across farmers is hardly equitable and their future in the light of the 2013 EU budget debate is hardly secure.
This post draws attention to two recent examples of best current practice for dealing with a problem bank that is not indispensable to the economy.
Key lessons: no need for capital injections if the bank is not going to survive; no protection for unguaranteed subordinated debt holders. In a nutshell, the problem bank is wound up; the guaranteed depositors transferred to a strong bank.
While it is now clear that Lehman Brothers was too large and complex a bank to be wound up, this is not true of many other banks. Indeed, even since Lehmans a number of quite large banks have been intervened. The cases of Washington Mutual and Bradford and Bingley are instructive for any authorities faced with a problem bank whose continued operation is not vital to the economy.
These banks were seen by the authorities as having no viable future, and as not being indispensible to the economy. Their continuing business was transferred to other banks. Government only injected sufficient funds to cover insured depositors: no new capital was needed as the rump banks were gradually being wound up. Holders of uninsured and unguaranteed subordinated debt and preference shares faced heavy losses (they had been earning higher interest in recognition of default risk).
On September 25th, 2008, Washington Mutual, one of the largest banks in the US, was intervened by Federal Authorities. Its insured deposits and mortgage book was sold to the bigger bank JP Morgan Chase. Retail customers were able to continue access their accounts the following morning and in the same old branches, but now owned by JPM. Little or nothing was left to pay WaMu’s $22.6bn in unsecured debt, let alone the shareholders. See: www.fdic.gov/bank/individual/failed/wamu.html
On September 29th, 2008, Bradford and Bingley, a large UK mortgage lender, was intervened by the British Authorities. All of the deposits were transferred to Abbey National and depositors had continued access to their funds through the B&B branches, now operated by Abbey. Mortgage holders continued to make debt service payments to B&B, now owned by the Government. Subordinated debt holders will lose much of their investment. See: www.hm-treasury.gov.uk/press_97_08.htm
The Financial Times this morning carries the story of Sean FitzPatrick’s departure from Anglo Irish Bank. The article provides links to the “AIB Statement” and “AIB Chairman’s Statement.” There’s a reason the media in this country use Anglo as shorthand for Anglo Irish Bank.
Carmen Reinhart and Ken Rogoff have released a new cross-country empirical study “Banking Crises: An Equal Opportunity Menace“. Their analysis shows that the average fiscal impact of a banking crisis is to increase the level of public debt by 86 percent, such that the public debt nearly doubles. They also show that the typical duration of a housing bust is 4-6 years.
Such cross-country averages are useful benchmarks and it is useful to think about the reasons why the current Irish crisis might deviate from such patterns.
Update: Reinhart and Rogoff have also just released a much shorter companion paper “The Aftermath of Financial Crises” [to be presented at the January AEA meetings in San Francisco].
The Irish government’s economic recovery plan can be found here. This report has a wide-ranging agenda.
For university-based economists, the following section is especially interesting, since it may represent an important shift in the government’s approach to funding research:
“The creation of more concentrated research-intensive excellence will enhance the country’s reputation internationally and its ability to attract top-level researchers and will underline Ireland’s intentions in terms of the development of the Smart Economy. It will also enhance the international exposure of Irish
universities and institutes of technology.” (page 75)
A busy day for CSO releases. The quarterly national accounts are published here, while the BOP data are here. In addition, the CSO released the 2006-2007 data for services trade, which can found here.
A striking feature of the data is the wide divergence between GNP and GDP for Ireland, with the most worrying data point being the 0.9 percent decline in GNP during the 3rd quarter (corresponding to an approximately 3.6 percent contraction at an annualised rate). The widening of the current account deficit, despite the slowdown, signals the external competitiveness problem.
Statcentral.ie is a new CSO-maintained data site that brings together all the CSO data, plus data from a range of other official agencies.
Brendan Walsh was the guest on the Eamon Dunphy show last Saturday. You can listen to the interview (which covers the current crisis, amongst other topics) here.
CES Ifo’s latest quarterly Forum has just appeared with a special issue on the financial crisis with articles by Hans Werner Sinn, Barry Eichengreen, Martin Hellwig, and yours truly, among others.
Download it free at http://www.ifo.de/portal/page/portal/ifoHome/b-publ/b2journal/30publforum.
My piece develops the argument that containment and resolution policy started too slowly and emphasized liquidity rather than solvency issues. True of Ireland as elsewhere. Only now are some of us coming to terms with this.
Two current policy problems for Ireland are to tackle the loss of external competitiveness and to determine the appropriate level and composition of government spending. These issues are linked, since government spending affects the real exchange rate for Ireland, through its impact on the relative price of nontraded goods in terms of traded goods.
In a new paper “Fiscal Policy and International Competitiveness: Evidence from Ireland” (joint with my TCD colleague Vahagn Galstyan), we show that the long-run behaviour of the real exchange rate and the relative price of nontradables is increasing in the long-run level of government consumption but decreasing in the long-run level of government investment.
The intuition is that government consumption tends to drive up economy-wide wages and nontraded prices (since the public sector competes for scarce labour and non-traded inputs), while government investment in the long run improves productivity (especially in the non-traded sector) which is associated with a reduction in the relative price level.
The appropriate levels of government consumption and government investment depend on a range of socio-political factors, but these results are worth noting in any debate about the connections between fiscal policy and external competitiveness.
The ECB has released its latest Financial Stability Review. From a domestic perspective, the report highlights that Ireland has seen the sharpest decline in commercial property values, from the fastest-growing market in early 2007 to the greatest contraction in 2008, with the gap growing over the course of the last few months. Similarly, the Irish residential property market is the worst performing in the euro area.
The next meeting of The Statistical & Social Inquiry Society of Ireland will take place on Tuesday, 20th January 2009, starting at 6 pm [SHARP], at the Royal Irish Academy, 19 Dawson Street, Dublin 2. The President, Dr Donal de Buitleir, will be in the chair when Mr Michael Moloney and Dr Shane Whelan (UCD) will present a paper titled Pension Insecurity in Ireland. The text of the paper is available at www.ssisi.ie, and an abstract is set out below:
The annual amount of the state subsidy to occupational and private pensions in Ireland is double that previously believed and is of the same order as the total annual payments under the state flat-rate contributory and non-contributory pension schemes. We ask: does the state get value-for-money from these subsidies? To answer the question we introduce the fair value approach to value pension entitlements. The current regulatory regime is shown to be very weak, with the security of pension entitlements of those in employment below that of investment grade debt (so the pension promise if tradeable would have junk status). We suggest and analyse measures to improve members’ security and recommend that the fair value of pension entitlements be made a debt on the sponsoring employer and that there should be regular disclosure to members of the level of security backing their pension entitlement. The former only gives a minor increase in security in an Irish context but the latter incentivises members to make other provision for their retirement. We conclude by suggesting that the state has a larger role to play in pension provision in Ireland in the 21st century than it played in the last century.
Tuesday’s FT has a long piece on the Spanish banking system: you can read it here. An interesting difference relative to Ireland is that the Bank of Spain insisted on banks building up reserves against general future risks. However, these provisions are not formally counted as part of its capital base and the general push towards higher measured capital ratios means that the Spanish banks are also looking to raise capital. This may reduce the chances of these banks getting involved in acquisitions in Ireland, at least in the near term.
Garrett had an article in the Irish Times on Saturday which I thought made an important point: the scale of the deficit is so large, that to claim it can be fixed by expenditure cuts alone is inherently implausible. (Although a pay cut for people like us would certainly help.) Presumably (?) the government understands this, and doesn’t really mean it when it claims there will be no more tax rises.
So: what tax increases will do the least damage to the economy? Like expenditure cuts, all tax hikes will obviously drive the economy further into recession, but given that we have no choice here, the question as to what is the least-worst strategy seems worth posing.
The latest round of international negotiations under the United Nations Framework Convention on Climate Change in Poznan reached its conclusion last week. The parties to this convention meet twice a year. The latest talks were a preparation for the Copenhagen negotiations scheduled for late 2009. Nothing much happened in Poznan. These were talks about talks. Should one pity the civil servant who attends these boring meetings, or envy her for all the foreign travel at the taxpayers’ expense?
By the way, the Irish taxpayer need not worry about such expense: The Irish delegation to the climate negotiations travels on account of official development aid. Poor foreigners foot the bill.
The irrelevance of Poznan is best illustrated with the fact that the European Council met during the “crucial” end-phase of the Poznan conference — and made decisions about European climate policy. The decisions are bizarre from an economic viewpoint.
The main target of European climate policy was unchanged. We will reduce greenhouse gas emissions in 2020 to 20% below their 2005 levels. A number of countries expressed concern about the costs of meeting such a strict target. These worries were placated by grandparenting more emission permits, and auctioning fewer. This is exactly wrong. Cap-and-trade with grandparented emission permits is roughly equivalent to a carbon tax with lump-sum recycling. Cap-and-trade with auctioned permits allows for a smarter recycling of revenue. In fact, almost any recycling scheme is smarter than lump-sum. In this particular case, the revenue is essentially a capital subsidy to energy-intensive industries (but long after credit will be uncrunched), although it can also be interpreted as a windfall profit. The agreed compromise is not bad for the environment as some environmentalists have claimed because emission targets are the same. The agreed compromise is not good for the economy either, contrary to the claims of the politicians involved. It is bad for the economy, but good for shareholders in energy-intensive industries.
The government has announced the launch of its recapitalisation process. The official statement is here.
It is up to each bank to decide its recap strategy. It will be interesting to observe the extent to which the major shareholders of each bank become actively involved, relative to leaving it to the management teams to develop these strategies.
Another instalment of miserable analysis to help maintain the festive spirit! This time, on cross-border shopping, patriotism and the real exchange rate.
Also, a paper by Olivier Blanchard on Portugal that got me thinking along these lines:
It all suggests that, as far as public sector pay is concerned, the commentariat is focused on quite the wrong question. It’s not whether there should be a public sector pay freeze, it’s how big the pay cut should be.
Responding to Labour leader Eamon Gilmore’s suggestion of a fiscal stimulus at his party’s recent conference in Kilkenny, Jim O’Leary argued in yesterday’s Irish Times that the option is unattractive. I would like to expand on some of Jim’s points and offer a few more.
The first is that the Government’s fiscal targets for 2008-2011 will in all likelihood be over-shot significantly in 2008 and 2009, and will be hard to hit in the terminal year of 2011. The targets are (as per the Budget Stability Update), GGB deficits for the years 2008 to 2011 at 5.5%, 6.5%, 4.7% and 2.9%. The gross debt grows from 36% through 43.4%, 47.5% to 47.8%, while net debt starts at 25% and grows through 31% to stabilise at 34% for both 2010 and 2011.
To begin with, the out-turn for 2008 will be a GGB deficit of maybe 6.5%: the NPRF vauation was 10% of GDP at end-June, but can only be 9% at best now; and GDP for 2008 will probably come in under the figure assumed in this table. At end 2008, gross and net debt ratios will likely be 2 to 3 points higher for these reasons. But borrowing in 2009 could be in the 8 to 9% zone, rather than the 6.5% target, and the assumed growth in NPRF value in 2009 may not happen. There could be bank bail-out costs not included in the budgetary arithmetic. At end 2009, gross debt will likely breach 50% (of nominal GDP below the 2008 outcome), and the net debt ratio could approach 40%. These would be the numbers before the fiscal consolidation begins!
There is a casual assumption being made by some commentators, and possibly some Governments, that the sovereign debt markets will pony up whatever is required, at least for developed countries and certainly for Eurozone members. But Germany struggled with a bond issue during the week, secondary markets are illiquid, spreads have widened and the weakest Eurozone member (Greece) trades 1.65% above bunds at ten years. The second-weakest is Ireland at 1.35%, and some Eurozone countries with worse debt ratios are trading on narrower spreads than us.
Martin Wolf argued in the FT during the week that a weaker Eurozone member could, in principle, default. There cannot be a currency crisis, but there can be a credit crisis instead. Greece is the current bookie’s favourite, but Wolf described Ireland as ‘…a dramatic case’, noting the speed of the fiscal deterioration and the over-leveraged private sector. The system as a whole needs to de-leverage, and there is no point offsetting a necessary balance-sheet improvement in the private sector with a public borrowing explosion. Indeed, de-leveraging the public sector through liquidation of the NPRF at some stage, and crystalising the painful losses, will need to be addressed. If you can’t easily sell debt, you may have to sell equities, as many hedge fund managers have discovered.
Any attempt by Government to stimulate will run up against Ricardian Equivalence anyway, even more so in the UK version, where the tax reductions are accompanied by specific commitments to increase taxes later. If the private sector is determined to improve its balance sheet through cutting consumption and investment spending, fiscal easing will either fail, in which case it is pointless, or ‘succeed’ at the cost of frustrating the unavoidable private sector adjustment.
Finally, Mr. Gilmore proposed specific capital spending initiatives, such as school building. These may be better projects than some other components of the capital programme, but it is notoriously difficult to fine-tune with capital spending.
Sheltering under the Irish Government’s guarantee, the Irish banks have survived massive falls in their share prices.
In each case the current market price is less than 10 per cent of its peak — 2 per cent in the case of Anglo Irish Bank. Value to book ratio (using the last annual accounts) varies between one fifth and one sixteenth.
Time to recapitalize, then, I would guess. When the regulator finally decides to require them to increase their capital (not least to reflect the large foreseen losses of the “incurred but not reported” type), the Government will have to be ready to participate. But how?
For some ideas and a cautionary comment by an academic scribbler, see today’s Irish Times: http://www.irishtimes.com/newspaper/opinion/2008/1211/1228864660643.html
The European Commission have just released a new working paper by Lars Jonung, Jaakko Kiander and Pentti Vartia that examines the boom-bust-recovery cycle in Finland and Sweden.
The paper is available here: The great financial crisis in Finland and Sweden – The dynamics of boom, bust and recovery, 1985-2000
The CSO last week released its index of employment in the construction sector. This index has 2000 as its base year, with 100 the average value of the index in 2000. The index peaked in September 2006 at 113.8 and the October 2008 value is 83.6: this represents an 18.1 percent decline since October 2007 and a 26.5 percent decline from its peak.
Ireland is not the only country undergoing a sharp contraction in housing and it is interesting to learn about the policy debate in other countries (especially fellow members of the euro area). This new article on VoxEU gives a good overview of the current debate in Spain:
This website got a plug today in Alan Ahearne’s “Short View” column in the Sunday Independent. The article asked whether the Government should heed calls for a fiscal stimulus plan for this country. Ahearne concludes that the answer is an unambiguous no.
Cuts in VAT rates, along the lines introduced in the UK, would do little to bolster economic activity in this country. Part of the tax cut may not be passed on to consumers. Moreover, a substantial chunk of Irish households’ spending is on imported goods. Increased spending on imports provides only limited support to our economy. The bang for the buck from a VAT cut is small in an open economy like ours because much of the impulse leaks out through higher imports.
A stimulus proposal might be effective at boosting transactions if it were huge. But the country can’t afford such a plan. Claims that a VAT cut could be self-financing are baseless. The Dept. of Finance estimate that the 0.5 percentage point hike in the standard VAT rate in Budget 2009 will raise €220 million. A crude extrapolation would suggest that slashing VAT to the UK rate of 15 per cent would add another €3 billion to the State’s already enormous borrowing requirement. As argued previously on this website under the post “On Deficits and Debts” (3 December), there’s a limit as to how much the Government can comfortably borrow on international markets.
A cut in VAT would also likely do little to stem the flow of shoppers across the border with Northern Ireland. Price differentials between the Republic and the North largely reflect the weakness of sterling and differences in business costs. A fiscal stimulus won’t solve these problems. A focus on improved competitiveness and realistic wage-setting would be much more valuable. Meanwhile, budgetary policy should aim at avoiding national bankruptcy.
Nice article in the Irish Times today by Jim O’Leary. I particularly liked the following unusually honest section:
The case for borrowing more to fund an attempted stimulus package would be more difficult to rebut if there was a high probability of it being successful, but fiscal stimulus is notoriously difficult to effect in a very open economy like Ireland. The reason is that a high proportion of any increase in demand leaks out through imports.
From our point of view, the best sort of stimulus package are those put in place by our trading partners since these boost demand for our exports without costing us anything. And here, the good news is that most of our main trading partners have announced reflationary fiscal measures of one sort or another in recent weeks/months. What we need to do is ensure that we are well-positioned to avail of the opportunities that will flow from these and what that means, first and foremost, is reducing our production costs to competitive levels.
It is hard to disagree with the logic. If the amazingly profligate government we have had over the past decade had listened to people like JOL on issues like benchmarking, then we might have tried to pull our weight as part of a Europe-wide reflationary package, but as things stand, we are going to have try to free ride. Not very glorious (and rebalancing the books will obviously make a bad recession worse) but there you are.
But let’s hope that too many others don’t also take a similar view! The thing about free riding is that what is individually rational can be collectively disastrous. Dani Rodrik is gloomy here.
The Central Statistics Office, Financial Accounts Division, National Accounts has released “Institutional Sector Accounts: Financial 2001 – 2007 (Revised)”.
An e-copy of the release is available on the CSO Website.
An Excel version of the tables from the release is also available on the CSO Website.
In case you can’t wait for blogger PH’s rivetting radio lecture: “The Financial Crisis: Ireland and The World” (recorded yesterday before a live audience but not being transmitted until St Stephens Day), you can get the text here.
It’s mostly an interpretation of the causes of — and policy reaction to — the global crisis, and corrects several common fallacies or half-truths.
The Ireland-relevant take-away: Our banking problems were caused by globalization…but not in the way you may think.
It was the fall in interest rates on euro adoption that triggered much of the bubble; easy access to international funding that fuelled it.
(Irish banks’ net foreign borrowing 2003-7 amounted to 50 per cent of GDP; Icelandic banks didn’t do any net foreign borrowing!).
Colm McCarthy provides an interesting analysis in the Irish Times today (December 3rd 2008) about the poor November tax returns. A key issue raised by Colm is the market’s appetite for sovereign bonds, in view of the projected rapid increase in issuance across the advanced economies. Since there is a general increase in risk aversion, it will be important to ensure that Ireland is perceived as a low-risk sovereign. To this end, it is important for the government to establish a new multi-year fiscal programme that shows how the growth in public debt will be managed, with a clear plan to return the debt to a sustainable path once economic recovery takes hold.
The general budget balance for Ireland has sharply declined, with a surplus in 2007 being transformed into a deficit of at least 5.5 percent of GDP in 2008 and a target deficit of 6.5 percent of GDP in 2009.
The appropriate fiscal balance for Ireland was the subject of a panel discussion at the ESRI Budget Perspectives 2009 Seminar in October 2008. Papers and/or presentations by Ray Barrell, Joe Durkan, Patrick Honohan and Philip Lane are available here.
There is also a relevant paper by Philip Lane from the ESRI Budget Perspectives 2008 Seminar, held in October 2007: ”Fiscal Policy for a Slowing Economy” .
More generally, the appropriate fiscal policy for a small open economy that is a member of EMU is the subject of an IRCHSS-funded research project that is led by Philip Lane. You can learn more about this project here.