Most independent economists think that the Government has basically taken the correct strategy on the budget. But many have real difficulties with the Government’s approach to the banks. Over the next few posts I am going to analyses the banking situation and explain why I (and other economists) have such a problem with Government policy.

The basic problem is that the government has shifted far too much of the cost of cleaning up the banking mess on to the  shoulders of the taxpayers. In the end there has been a bailout – but not a bailout for developers. It has been a bailout for bondholders. In order to understand why the government did this and why most independent economists think this is a bad idea, we have to take a step back and think about how what a bank actually does.

Basically a bank takes money from depositors and lends it out to borrowers. The bank makes a profit by charging borrowers higher interest than it pays its depositors. So far, so obvious.  But what happens if some of the lenders default on the borrowings from the bank? In that case the bank could seize the borrowers’ assets, sell them off and use the proceeds to pay off the loan. But what if these proceeds were not enough to meet the loan? If the gap is large then the bank would not have enough money to payback its depositors and the bank itself would have to default. The depositors would bear the loss. They would probably get most of their money back through normal bankruptcy proceedings– but not it all.

Obviously this is not desirable from the point of view depositors. So over the centuries, the practice grew up of the owners of banks putting up some money so that they could guarantee that depositors would be paid even if borrowers defaulted. This “up front money” is the so called “equity” or “capital” that we keep hearing about. Nowadays, this equity is required by law and international treaties with various different technical requirements (such as the Tier 1  2 capital requirements you keep hearing about).

From the above discussion it is clear that the system has a problem. What happens when the borrowers default to such an extent that the losses are greater than the “up front” money put up by the banks owners? Answer: the bank must default on depositors — unless somebody does something.

Somebody did do something in September 2008 when the government announced it would guarantee the banks’ liabilities.

The became necessary because large sections of the banks assets (i.e. loans) are about to default. The focus initially was on the large loans to developers. But eventually there will be defaults on some mortgages, car loans credit cards etc. Default in itself is not the problem. If the borrowers defaulted the bank could seize collateral. The problem now is that almost of the collateral is property related and is therefore worth much less than the value of the loan it backs. How much less? We don’t know, we can only estimate. For the sake of simplicity let’s assume that the assets are now worth 50% of the loan book (this would be in line with my analysis of the housing market given here). This would wipe out the equity in most of the banks. In the light of the September guarantee, the difference would be met by the Irish Taxpayer. This is the root cause of the cash that we the people have had to throw at our banking system. In the next few posts, I will take a more nuanced look at some aspects of the government’s plan.

Another international economist to comment on the Irish situation is Roberto Rigobon. Roberto doesn’t have a big media profile but he has well known and respected in the profession. Furthermore, unlike most economists, he has devoted his entire career to studying financial crises. He is very up beat about the current suituation. He points out that crises, like the one we are in now, actually occur quite often. The only difference is that they happen in the developing world,  so we in the west tend not to pay much attention. Nevertheless, according to Roberto, we can learn from the experiences of Thailand, Argentina etc. His basic point is that with the correct policies they bounced back pretty quick. He thinks we can do the same. Furthermore, he thinks that the policies followed by the US government are right on track. He outlines his points in a very amusing article here. It is well worth a read. Trust me, it will leave you feeling better afterwards!

Nobel Prize winning Economist and New York Times columnist Paul Krugman has commented a few times on the Irish situation. I am a great fan of Krugman, he is a bone-fide genius, a great lecturer and a very clear writer (unlike most economists!). He has a great ability to simplify and demystify complicated economic theories.

Krugman’s message for Irealand was a little pessimistic. He fears that Ireland — and indeed the rest of the world — may be heading for a 10 year long recession like Japan in the 1990s. He acknowledges that world governments are reacting to the shock much better than the Japanese government. But he fears it may not be enough. In the specific case of Ireland, he predicted up to five years of pain as domestic costs adjust. He pointed out that the ideal solution of a devaluation was not available to us because of our membership of the euro. In fact, our currency has appreciated against sterling (until recently)— precisely the opposite of what we need.

Krugman is correct, of course. But I think he is too pessimistic on the time frame for our costs to adjust. In the absence of a devaluations, the only way for our exports to become cheaper is for wages (and other costs) to fall.  Normally,  this would take years to happen. Hence Krugman’s assessment of five years of pain. What is surprising about the Irish case is that and adjustments seems to have happened within months. Public sector salaries have fallen by 10% via the “pension contribution”. This occurred with only the minimum of whining. Anecdotal evidence suggest that similar cuts have happened throughout the private sector. Could any body imagine the same happening in France? There would be riots in the street.

Time to open up a new category of posts: international perspectives on Ireland by Seriously Smart People.

First up is Nobel Prize winner, Joe Stiglitz who was in Ireland last year. He gave an interview to the Irish Times in which he annoyed to government by not being entirely enthusiastic about the NAMA etc.  He addressed three issues that we will return to repeatedly in this blog: competitiveness; the deficit; and NAMA.

On competitiveness he noted that we had to get our costs down so that we cand grow exports to get out of the recession. If we had out own currency, we would be able to devalue. This would reduce the prices of our exports in terms of other currencies and thus boost exports. This achievement would come at the cost of boosting inflation by requiring us to pay more for our imports. Thus living standards would fall as prices rose. Stiglitz advocates reducing wages (and other costs) directly so that the price of our exports can fall. We will look at this in detail soon.

On the deficit, Stiglitz also noted that there was a need to get the public finances under control. But he warned that there was a need to avoid what he called “deficit fetishism” i.e. avoid too large an adjustment which will only make the situation worse. It is a balancing act. I discussed this issue more fully in a previous post.

Finally, Stiglitz commented that NAMA and other similar plans can be too generous to the Banks. He advocated adhering to the “rules of capitalism” which says that if a company screws up badly then the shareholder should — and usually do — loose their investment. NAMA, however, is deliberately structured to preserve some degree of shareholder value via a deliberate over-payment for the bad loans . Evidence of this can be seen from the fact that the share price rose immediately after the details of NAMA were announced — of course they did — we had just given the shareholders a pile of free money. Essentially Stiglitz advocated some version of NAMA that would pay less for the bad loans implying that shareholders would loose their investment and requiring that bond holders would also take a hit. Only depositors should be guaranteed to suffer no loss. This is a huge issue and I will devote several posts to it next week.

A couple of  posts ago, I talked about the new found fondness for austerity throughout Europe. As I mentioned, it isnt 100% clear that this is a good idea. It will probably make the recession worse. But for a country as indebted as Ireland , it probably makes sense. If we donbt curb  our borrowing, we might run out of people willing to lend us money at a reasonable rate.

So if we are going to cut the deficit should we increase taxes or reduce expenditure? In the last budget the government chose large reductions in expenditure and relatively small increases in taxes. The recent UK budget took a similar path. Whether this is a good or a bad idea obviously comes heavily loaded with ideological or philosophical considerations. Is there anything objective to be said?

Fortunately the answer is yes! Let me be up front and say that I believe that the evidence points to expenditure cuts being better than tax increases. There is a large body of economic literature that studies large scale fiscal crises. The main conclusions of this literature is that plans to solve these crises based on increasing taxes tend not to be successful, while those based on expenditure cuts do tend to be successful. The reason is, presumably, that tax increases need to be large to close the deficit. Large increases in tax rates reduce the incentives for people to work and pay tax and so, in fact, end up generating much less revenue than was anticipated. The net result is that even though tax rates go up, the deficit is not reduced.

Of course this isn’t an iron law of nature — it is just an observed relationship that tends to hold in practice. But it is informative. If we propose to go in the opposite direction and increase taxes for philosophical reasons, we would have to ask why would expect it to work here and now when the international is experience suggests it wont? Why is Ireland different? Ireland might be different of course, but we would need to be clear why this is the case.

In fairness, the methodology used in this lieterature has been criticsied — inluding by me with my academic hat on. Nevertheless, I dont think that these criticisms are fatal to the overall conclusion. In addition recent work by Philip Lane from TCD has shown that the effect on the economy of cutting public sector salaries is less damaging than that of cutting taxes. Both these pieces of evidence (the international experience and Lane’s work) suggest that expenditure cuts are the way to go in order to stabilize the budget. But there is a philosophical consideration. Expenditure cuts will inevitably hurt  vulnerable people in society. We may decide to go with tax increases (even if they are less likely to work) for moral reasons. But we must be honest and acknowledge that we adopting a policy that is less likely to work and may only be postponing the inevitable. If that is so, then we are not doing the vulnerable (or anyone else) any favours.

A slight digression from talking about the budget. Today the Irish Times reported that the recession was over. By this they meant that economic activity as measured by GDP had started to rise again in the first quarter of this year. The question is when will we begin to feel this rise. In particular when will unemployment (currently just below 14%) start to fall? Or will we be in for a period of protracted “jobless growth”.

In fact the link between growth of GDP and unemployment has long been discussed in economics. The link is known as Okun’s law. Like most economic “laws” it is not really a law at all. It is not something that must hold, it is just a relationship observed in the data — and one that appears to hold most of the time.

The graph above shows Okun’s law for Ireland. As can be seen there is a negative relationship between growth and unemployment. As growth rises, unemployment falls. The solid line indicates the average extent of that relationship. Historically, on average, a fall in the unemployment rate of one percentage point would usually require growth to rise by 1.11 percentage points. However, this is only the average relationship. As the scatter plot indicates there have been some years of high growth and little change in unemployment and vice versa

So we clearly have to be wary of making forecasts on the basis of the average relationship when there has been considerable variation on either side of that relationship over the last few decades. Nevertheless the average relationship provides a reasonable starting point for such a forecast. So what would need to happen (according to Okun’s Law)  if we are to get unemployment down from the current level of 14% to a more respectable level of 6%? According to Okun’s law an 8% fall in employment would require growth of 6% every year for 5 years. This is a tall order at the best of times. It will only be possible if week keep domestic costs under control and if the world economy rebounds strongly. Failing that, we could be in line for an extended period of jobless growth.

There are some commentators who advocate a large reduction in the deficit and who argue that this reduction will actually lead to an immediate expansion in the economy. This “Expansionary Fiscal Contraction” view has been advocated by German officials recently. It is obviously at odds with the orthodox view described above. The way the the EFC is supposed to work is via private sectors expectations. The idea is that in a time of crisis with large deficits etc, the private sector cuts expenditure because people are scared and are hoarding their resources. If you take extreme measures to solve the budgetary problem, then the private will relax and start spending again.

There is obviously something to this — if your crisis is severe enough.  On the other hand its sounds far too good to be true. It’s like having you economic cake and eating it.  Is there any evidence that EFC occurs? Ironically, the budgetary crisis in Ireland in the 1980s is often cited as an example of an EFC. For those too young to remember, the story goes like this: In the 1980s the Irish economy went from bad to worse. Unemployment was huge, wages low, emigration unprecedented, huge deficits and explosive national debt. In 1987 the new government, cut expenditure dramatically. From that year the economy began to grow and Celtic tiger was born. On a superficial level this provides support for the EFC hypothesis. However a closer look shows that it was largely a coincidence. The Irish economy grew rapidly after 1987 because of a huge boom in exports that were, in turn, caused by a falling labour costs and a depreciating exchange rate.

More formal research has suggested that EFC effects can occur, but the evidence for them is weak. I certainly don’t advocated testing to see if we can get one now by engaging in huge cuts in the deficit.

There has been a lot of talk recently abut austerity. The recent UK budget emphasized that the deficit had to reduced. The G20 summit suggested that this approach should be adopted by all countries. There are worries about the size of the US budget deficit. In the last few days, there have been strikes in Greece and France against austerity plans. So it seems timely to put a few posts up on what governmentsshould do in the current situation. Overall there seems a growing consensus that pain is good — it builds character. The world seems to be going S&M.

It is far from clear that it is a good idea. In fact, orthodox economics advises that taxes should be reduced and expenditure increased in a time of recession i.e. deliberately induce a large budget deficit. The idea is that the net government expenditure will replace some of the private sector expenditure that is missing in the recession. This should help boost demand and ease — if not eliminate — the recession. When the good times return, taxes can be increased to pay back the debt accumulated during the recession. Normally this approach works well (although there can be problems persuading people to accept higher taxes in the good times). It is clearly the motivation behind the  US stimulus package and the UK’s approach under Gordon Brown.

However, a problem might arise in very extreme situations such as we now face. With the deficit in Ireland, US and UK already expected to be well above 10% there is little scope to increase it further. International investors might be quite reluctant to lend money to a country whose deficit was heading much higher than that. And if they did lend, it would only be at a high interest rate. Nobody wants to be the next Greece.

So if we shouldn’t increase the deficit, The question becomes by how much should we reduce it now? The answer, I think is “not by much”. Probably not much below 9%. Any reduction in the deficit is going to have a negative impact on the economy. At a time when private sector expenditure is falling, we are going to reduce net public sector expenditure. It is like kicking the economy when it is down. However, there is good reason to believe that a moderate reduction in the deficit is not so bad for a small open economy like Ireland. The reason is that the reduction in the expenditure will not fall entirely on the domestic economy. Simply because we import so much in Ireland, any decline in public expenditure will be felt as much by our major trading partners as by us.  As a result, a reasonable guess is that the effect of any change in budget deficit  on GDP in Ireland is half what it would be in the US. Of course it isn’t zero — we will feel the pain. The UK will probably feel the effects of its austerity more as it has a slightly less open economy than us. In fact, as the UK is still our major trading partner, we will feel some pain as a result of their austerity. In fact, if austerity does become the norm in the US, UK and Eurozone, demand for our exports would probably fall. This will make it more difficult for us  to recover from recession.

It may be a strange thing to say, but the housing collapse is not all a bad thing. Certainly there is a mess to clear up. But the mess would be even larger had the boom continued. In a nutshell the housing boom involved a collassol waste of  resources. It is a good thing that we have stopped.

I have commented before on how the bubble in house prices was fairly obvious even while it was still going on. The rise and rapid fall in house prices gets a lot of attention but the waste of resources. This doesn’t get the attention is deserves. Understandably most of the discussion is focused on the consequences of the bubble for the public budget and the banks. In the long term these issues will be resolved — however painfully. But we will still be left with a legacy of a decade of bad investment.

The reason for this bad investment is now fairly obvious: people respond to prices. And People responded to the rapid run up in house prices by devoting more national resources to housing construction. Landowners sold more land for development; builders built more houses and punters bought them. All thought that they were behaving sensibly because the price kept rising.

The graph shows the the size of housing construction as a percentage of GDP in several countries, including Ireland over the last decade (double click on it for a larger version). It is clear that Ireland was an outlier. At its peak, housing construction was 14% of our GDP compared to an average of 6% for the OECD as a whole. That means that an extra 8% of our national effort, on an annual basis, was devoted to housing construction. Formally speaking this is counted as “Investment” in GDP. Although it is fairly obvious now that much of this was not investment in the usual sense of the word i.e. was not going to enhance productive capacity in the future.

Nevertheless this expenditure contributed to GDP (one seventh of GDP at its height). People directly involved in the construction industry obviously benefited. But everybody else did also as the income generated trickled down to the rest of the economy.

When the bubble burst, it became obvious that property wasn’t the good investment it had appeared to be. Thus construction halted almost over night. And therefore, 8% of our GDP disappeared almost overnight. This loss tricked down to the rest of the economy in just the way that the construction boom had trickled down to everyone else. When 8% of your economy disappears over night, you notice the pain. That, in a nutshell, is where our recession came from.

Note that we would have this recession when our bubble burst even without the international credit crunch. The international problems just make our own more difficult to deal with.

But note also, that the bursting of the bubble, though painful now, is ultimately a good thing. As long as it continued, we would be wasting more and more of our resources in the unproductive investment in housing. Stopping that waste is a good thing in the long run. Our resources can now be put to better use elsewhere. Unfortunately in the very short term, the two main “better uses” seem a bit troublesome. Ideally the government should take advantage of the crash in construction to speed up the development of much needed public infrastructure. But of course, the government hasn’t got the cash to fund such a plan at the moment. The other way in which our resources could be better put to use is in export earning industries. This would be useful as we will need to foreign earnings to pay back the foreign borrowing made during the bubble (more on this in a future post). Will only be able to stimulate exports if we can cut our domestic costs.

Morgan Kelly is widely acclaimed as the economist who clearly predicted the current crisis and was prepared to say so in public to much criticism at the time. He takes quite a pessimistic view on house prices suggesting that they can fall way below even their current levels and by more than I suggested in the last post. His basic argument is that demand for housing will be very low for the foreseeable future as banks will be unwilling or unable to lend money to potential buyers. you can read his analysis here. I have to admit that his argument has a lot of merit. I think it is a bit too pessimistic as other lenders may fill the gap in the market. But as against that, Morgan has made a name for himself by being proven right!