Calmfors Driffill revisited

Everyone agrees that the Irish economy needs to restore competitiveness. Absent the possibility of devaluation, this either requires freezing nominal wages, and letting inflation erode their real value; or reducing nominal wages. The former course of action seems insufficient, since it will take too long, and we may even be heading for deflation.

So, the old Calmford Driffill literature from the 1980s may be relevant. (I couldn’t find their 1988 Economic Policy article online, but a survey article is here.)

Remember the basic point: if labour markets are very competitive, then wages will fall by themselves. If there are strong sectoral unions, on the other hand, then they may all play a game of ‘after you, my dear Alphonse’, and wages may not be cut. In that case, moving to central bargaining can help in coordinating wage cuts, in that no-one feels that they are falling behind in relative terms. Some would say that the introduction of social partnership in the late 1980s is a good illustration of that mechanism in practice. (OK, it involved wage restraint, not wage cuts, but that was useful in itself at the time, especially in the context of devaluation.)

The question for you all is: how flexible are private sector labour markets in Ireland today? We have all read about particular firms cutting wages, but how common is that? Are there studies on this? Will private sector wages fall sufficiently on their own, or is there a role for government coordination here?

Some unpalatable pension arithmetic

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.

Assets

Liabilities

Total €1 billion

To pensioners

€0.5 billion

To contributing members

€0.5 billion

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:

Assets

Liabilities

Total €0.6 billion

To pensioners

€0.5 billion

To contributing members

€0.5 billion

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!

2008 CSO agricultural output and income data disappoint

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.

4d27ef1a-cfbe-11dd-af3a-000255111976

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.

Dealing with a problem bank

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).

More detail:

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