Sunday Times Death Spiral Watch

Reading my Sunday newspapers for insights on the economic crisis, I came across the following from Damien Kiberd in the Sunday Times: “Two hundred economists gathered at UCD last week and all we heard from them were suggestions for more taxes: the reintroduction of domestic rates and third-level fees, taxes on child benefit, carbon taxes, taxes on social welfare, sucking the low-paid back into the tax net and higher excise duties. This is exactly what we did in the 1980s, when Ireland nearly went bankrupt.”

What a pity I missed that conference. Now I did attend an event on Monday at the Royal College of Physicians (organised by UCD and the Dublin Economics Workshop) and funnily enough that event had about two hundred people at it also. But there the similarities end. Participants at the conference I went to focused heavily on the need to cut public sector pay and of the range of tax measures mentioned by Kiberd, only one (reintroducing rates) was discussed. It’s rather strange of UCD to organise two different conferences on the same topic in the same week, but then that’s economists for you.

Let’s hope our new State-owned bank is not for forbearance

Two contradictory ideas about the consequences of possible failure at Anglo Irish Bank were going the rounds in the last few weeks.

The first idea — a strange one — was that any attempt to foreclose or restructure non-performing corporate creditors of Anglo Irish Bank would have an unfavorable “ripple effect” on the other banks, who also have lent to the same firms. (What kind of ripple? If it causes the other banks to wake-up and help restructure weak firms, that can only be good for everyone — except perhaps the controlling shareholders of the borrowing firms, who are currently living on borrowed times).

The second idea — not quite so strange — was that a bank being wound down would obviously do worse in recovering on the bad loans it had made. (That sort of thing has happened to China’s AMCs, but mainly where the AMC has decided to sit back and not pursue the recovery courses open to it).

Despite their doubtful validity, both arguments are now likely to be used to try to prevent the soon-to-be state-owned Anglo from pursuing delinquent debtors with vigour.

That would be a bad mistake both for the bank’s own recoveries, and for the economy as a whole.

State-owned banks around the world have tended to fall into the pattern of ending-up as lenders of last resort to large but barely viable companies with good political connections.

May I be permitted to repeat a paragraph from my conference paper of last week:

“Distressed firms need to be decisively restructured, and not kept alive on a drip-feed. The dangers here apply especially to property-based companies, but also to others. In other words, parallel to the financial restructuring of banks, there needs to be work ensuring that surviving non-financial firms are financially solid. This can be done largely by the market; the barriers to prompt action here are likely to come from banks that are in denial about the true financial condition of their biggest borrowers, and from political pressure.”

If nationalization means that previously cossetted Anglo borrowers are now going to be pursued energetically, it may prove to have been a good thing.

Bad Bank Bafflement

A number of comments on Kevin’s link to Buiter’s discussion of bank nationalisation have brought up the idea of a “bad bank” that can be used to take over non-performing assets.   I think this issue is important enough to hoist out of the comments and onto the front page!   It should be noted that Buiter is discussing this idea in the context of a fully nationalised British banking system.  The “bad bank” idea has an “economies of scale” advantage in that case. so that all bad loans can be grouped together and dealt with by a team specialising in getting the best long-run return for the government from working out bad loans.

Outside the context of full nationalisation, I’m not sure I understand the “bad bank” idea or why it has caught on in the Irish media over the last day or two.   I’ve been puzzling over this the last few days and then found a post by Paul Krugman that expressed my puzzlement far better than I could.  In a post entitled bad bank bafflement (good post title!), Krugman says: “The idea of setting up a “bad bank” or “aggregator bank” to take over the financial system’s troubled assets seems to be gaining steam.  So let me go on record as saying that I don’t understand the proposal.  It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.”

In the Irish case, perhaps someone could explain to me how the bad bank proposal gets at this question.  What price would the Irish government pay to struggling banks for their underperforming loan portfolios?  Why should the government pay a price above current market value rather than, for instance, provide additional capital to cover the implicit losses and thus increase the government’s equity share?

As Krugman notes, in the US case, the answer to these questions appears to be that Bernanke believes the market is systematically underpricing a wide range of mortgage-backed securities and that the US government may break even (or perhaps profit) from buying them at above market rates and selling them later or holding to maturity.  Whether Bernanke is right or not is open to question.  But is there any reason to think a similar logic applies to Irish commercial property loans?

Where is Ireland’s Tax Burden Heading?

In my discussion at Monday’s conference (slides here), I raised the question of where Ireland’s tax burden was going to settle down once the public finances have been stabilized. The Addendum to the Stability Report published last week by the Department of Finance shows how the Gross Budget Balance can be brought back to a deficit of 2.5% by 2013 through an adjustment process in which the revenue share of GDP stays roughly stable so that almost all of the adjustment occurs on the Revenue side. The document itself does not comment on the composition of the adjustment described in this table, so perhaps this isn’t an actual plan but instead an illustrative example. Still, it’s worth starting with as a baseline for discussing where we are heading.

I noted on Monday that the plan projects a government revenue share of GDP of 34% in 2013 and that this is well below the equivalent share for EU15 countries, which has been stable at about 45% for a number of years. A number of observers at the conference questioned this calculation on the grounds that the calculation should be done relative to GNP. In particular, since GDP has been about 17% higher than GNP in recent years, one might want to adjust the tax share upwards by this amount. Doing so would give a figure for 2013 of about 41.5%. This is still a reasonable amount lower than the EU15 average but not nearly as much as the figures I quoted

However, I do not view this higher GNP-based figure as a useful one, for two reasons.

First, I believe that GDP rather than GNP should be viewed as the correct tax base when making calculations of this sort. GDP represents all the income generated in this country and, technically, all of it is available to be taxed by the Irish government at whatever rate it chooses. Of course, profit income generated by multinational corporations is likely to move elsewhere if we tax it at a sufficiently high rate but this is an issue faced by all governments, not just our own.

Second, if one is going to exclude the substantial factor income repatriated abroad (€28 billion in 2007) from the tax base it is not consistent to then include the taxes earned on this income in the measure of the tax burden. Assuming that the €28 billion figure represents corporate profits repatriated after paying the 12.5% corporate tax rate, one comes up with a figure of €4.1 billion in taxes paid by multinationals on repatriated profits. Excluding tax payments of this magnitude would give a 2013 (adjusted) tax share of GNP of 39%. So, even if one agreed with the idea of GNP as the tax base, an internally-consistent calculation of the Irish tax burden would still leave it well below the European average.

The broader and more important point here is that we need a wider debate about the shape of future fiscal adjustment than the one currently taking place, which focuses almost without exception on the need to reduce public sector pay.

How fast is Irish inflation falling?

The twelve-month CPI and HICP rose 1.1% and 1.3% to December, and these numbers were duly headlined. But both indices have been falling in recent months, and it beats me why people use 12-month numbers in the middle of a big macroeconomic correction. Karl Whelan made a similar point here recently in the context of the quarterly national accounts.

There are small but significant seasonals in the CPI and HICP. The CSO does not adjust, but the following is based on up-to-date factors (an Excel file with the data and factors is available from john.lawlor@dkm.ie). Unadjusted, HICP showed small monthly changes in Sept, Oct, Nov, then fell 0.73% in Dec. The adjusted pattern was similar, but the fall in December lower, at 0.46%.

For unadjusted CPI, Sept and Oct showed only small changes, but then big falls of 0.93 and 1.21 in Nov and Dec. The adjusted falls were again smaller at 0.84 and 1.09 (but these are still very large month-on-month numbers).

Thus for the last two months, and seasonally adjusted, the CPI has dropped almost 1% per month. The HICP has been falling only for a month, and more slowly. The difference between the two is mostly about mortgage interest (see my paper in ESRI QEC for September 2007), and I think the HICP is a better index. When I expressed this view in 2007, the CPI was rising faster than the HICP, and my argument was described as academic (ie wrong) by ‘certain parties’ keen on compensation for inflation. A change of horse by these parties is confidently predicted (difficult manoeuvre at speed unless you are a Cossack).

Recent forecasts of FY 2009 CPI inflation are minus 2% (ESRI) and minus 2.5% (Pat McArdle of Ulster Bank). These numbers look well within range, but HICP could show a smaller fall than CPI if mortgage interest rates continue to drop. Either way, we are a long way away from mid-September, when the pay deal was negotiated. At that time, inflation looked set in a band around plus 4%. 

There is a big shift in the price index seasonals from December to January – if the adjusted trend is zero, the unadjusted shows a significant drop. If anyone quotes the unadjusted drop next month, they incur four faults.