The Irish Economy

Wolfgang Munchau has another thought provoking piece in Monday’s FT.   While he believes that the announcement of the ECB’s OMT programme has stabilised things for the near term, he remains pessimistic that the crisis – which he sees as fundamentally one of solvency rather than liquidity – is on a path to being resolved. 

Although I share many of Wolfgang’s concerns, my take is a bit different.    My starting point on the solvency issue is also quite pessimistic.    Defining state solvency is not easy.   A necessary condition is clearly that the debt to income ratio is not on an explosive path.   In terms of levels, we see that some countries (Japan being the most dramatic case) appear to be able to roll over debt and fund deficits even at debt to GDP ratios in the region of 200 percent.   On the other hand, low-income countries can struggle to be creditworthy with debt to GDP ratios of 20 to 30 percent.    Lacking their own central banks that can lend to governments in their own currency in extremis, euro zone countries with high debt/deficits and weak/uncertain growth prospects have been revealed not to be creditworthy.   In a very real sense these countries would not be solvent without official sector support – and are unlikely to become so for some time.   The important question then is whether official sector policies can be designed to allow countries to be robustly creditworthy.   Designing these policies faces a double credibility hurdle: that the support will be there (if only as a backstop) if countries meet the conditions for eligibility; and that it is credible that the countries availing of the actual/backstop support can meet the conditions. 

The requirements for effective official support policies seem to be the following:  (1) Supports must be reliable – countries must be able to rely on the support being there without forced PSI as long as they continue to meet the conditions.  Where PSI is deemed to be unavoidable, this should be recognised early and done decisively so that it can be taken off the table to the maximum extent possible.    (2) The conditions must be reasonable – taking into account underlying growth prospects and the negative impacts of fiscal adjustment on growth, the required adjustments must not push the political capacities of governments to push through large adjustments beyond the breaking point.  (3) The conditionality must be flexible – unanticipated adverse growth outturns should not lead to requirements for ever larger adjustments.   And (4) the link between banking-sector losses and state debt must be broken.  

Euro zone crisis resolution policies are moving slowly in this direction, although there is some way to go on both reliability and flexibility in particular. 

Following the IMF’s new analysis on the likely size of fiscal multipliers in a liquidity trap, there is a need to revisit the appropriate conditionality regarding fiscal adjustment.    But where the current policy stance leaves huge uncertainty over whether the crisis will be resolved, this must also act as a huge break on growth.   (I discuss this further in an Irish Times piece last week.) 

Of course, the policy mix described above is a big ask for stronger countries, either directly or through the ECB.   They are being asked to take on large risks and put a lot of faith in the willingness of countries to meet the conditions.   The development of the necessary crisis resolution and prevention policies must be seen as a two-way process, where all euro zone countries submit to tighter rules on budgetary management and more intrusive surveillance (see Mario Draghi’s recent comments in an interview here).   Much of the debate in the run up to the fiscal treaty referendum seemed to completely miss this point, reaching its nadir in complaints about a “blackmail clause” regarding access to the ESM. 

I believe the crisis can be resolved.   But only if the stronger countries recognise the kind of ongoing official support regime that is required to robustly restore creditworthiness, and all countries recognise the necessary pooling of sovereignty that is required to make this regime politically feasible. 

The debate over the private debt relief has developed a lot of momentum, with the both the Central Bank and the Department of Finance now seemingly increasing the pressure on banks to provide debt relief.   While there certainly is a case for targeted debt relief, it seems to me that there are a number of confusions in the debate.   I think the following points are worthy of some discussion. 

1.       The distinction between accounting loss recognition and debt relief

This is a point that has previously been emphasised by Greg Connor (see quote here).   The processes of loss recognition for accounting purposes and debt forgiveness are very different.    In part motivated by the Japanese experience, it was recognised early in the crisis that it is critical for banks to recognise losses and then to be properly recapitalised.   Failure to do so can lead to the “zombie banks” phenomenon, whereby effectively undercapitalised banks are unwilling to lend.    This can further be associated with “zombie borrowers”, whereby banks engage in “evergreening of accounts – essentially lending more money to prevent default – so as to avoid having to recognise the losses.  

Through the PCAR process, Irish banks have been forced to recognise losses and to be propertly recapitalised, although concerns about mortgage losses have left lingering doubts about whether the process has gone far enough.   But this process is consistent with banks doing everything possible to maximum the recovery of loans – even loans that they have written down on their books.   Minimising the need for yet further capital injections requires that banks only forgive debts if it actually increases the expected recovery.

2.       The “debt Laffer curve”

I have mentioned the “debt Laffer curve” before, but I think my exposition just caused confusion.   But I still think it is a very useful device for thinking about the case for debt forgiveness.   The basic diagram is here.    The horizontal axis measures the present value of payments to the bank assuming full repayment on a given debt obligation.   The vertical axis measures the expected present value of the repayment.   The “debt Laffer curve” shows the relationship between the present value of the debt obligation and the expected repayment.   The basic case for (mutually advantageous) debt relief comes from the possibility of the curve beginning to slope down beyond a certain point.   This means that debt forgiveness could actually raise the expected value of repayment.   This could happen, for example, if lowering the debt burden means the borrower has stronger incentives to raise their income or to avoid default (where repossession would b e costly for the bank).    Such cases are certainly conceivable, but it is a fairly demanding hurdle.  (I would be very interested in commenters’ views on this.)  

There is, of course, the extra complication of the much discussed moral hazard/strategic default.   If the bank provides relief for people in certain conditions, then there is the potential for a bad “pooling equilibrium” where people have the incentive to be in those conditions.   Colm McCarthy has famously put this in a pithy way:

Since you cannot get blood from a stone, it is desirable to streamline the personal insolvency arrangements so as to recognise this reality.  But no incentives should be created which encourage those who can pay to disguise themselves as stones.

Now it may well be that the government wants the bank to provide debt relief even where the curve is upward sloping but relatively flat.   The relief would have the added advantage that it could help stimulate household spending.   But if this is the policy, then it is better to admit up front that the policy means bigger losses for the bank and, where the bank is State owned, ultimately for the State.   There is a danger that State-owned banks will be forced to follow a range of political objectives, storing up longer term fiscal problems and making harder to gauge the ultimate performance of the banks.   If the government wants broader debt relief, then it is better to provide appropriate subsidies and then let the bank get on with – and be accountable for – maximising value. 

3.        Insolvency rules

One way to make it more likely that the bank has an incentive to forgive debt to prevent outright default is to strengthen the “threat point” of the borrower through more debtor-friendly bankruptcy laws.   Making bankruptcy or other insolvency rules more borrower friendly is likely to reduce the value of the banks.   But I think the focus here should be on the overall design of the regime.   The current regime is archaic and brutal and needs to be reformed.   If moving to a modern regime results in losses, then additional losses for the banks is a bullet to be bitten.

However, much of the discussion in pitched in terms of a trade off between debt and creditor rights – and creditors understandably get little sympathy at the moment.   But it is important not to forget the “instrumental role” of creditor rights in ensuring there is an incentive to provide credit in the first place.   Everyone’s creditworthiness is tied to there being reasonable protection of creditor rights. 

available here.