The real problem country in Europe….

This is an extended version of an opinion piece published in the Irish Examiner Saturday 25 May 2012

So another European summit concludes inconclusively, with the poor ole can again booted down the road, hopefully avoiding the fork that said road will take when, as seems probable, Greece departs the euro. To be fair, while inconclusive in terms of its outcomes there was a clear sense that the ground has shifted, away from the coordinated austerity for all pushed by Germany for the last two years towards a more balanced approach. Perhaps we should recall and amend the words of Churchill, substituting European for American and noting that Europeans will do the right thing only when all other alternatives are exhausted. Eurobonds, where a central or pooled treasury issues bonds and then doles out the cash to members of the pool, are at least back on the table, there is a recognition that growth needs to be at least as much a focus as fiscal discipline and there is an acceptance that bank recapitalization costs cannot fall only on the taxpayer.

However there is still a massive problem. Europe is mired in recession. Recent PMI indices, indicators of future economic activity, are all pointing recently to a deep slowdown. Spanish banks are treading the same dreary path as did Irish banks, with each deep look at the depth of the damage caused by its property boom revealing deeper and deeper holes, and the state adopting sequentially more and more drastic action to stem these holes. At least so far they have avoided a NAMA or bank guarantee fiasco. Meanwhile Greece continues to fester and the dreadfully dangerous precedent of an exit from the monetary union (which would render it no more than a fixed exchange rate zone, and we know how the last one of those in Europe ended) inches closer.

There can be no doubt looking at the economic history of the last decade that the biggest winner from the adoption of the euro was and is Germany. It has achieved massive relative competitive advantages over the other nations, mainly it must be admitted by the less than optimal actions of these countries, but also by reducing the labour share of the German cake. From close to 70% in the 2000 period employees compensation as a % of GDP is now closer to 60%, and German net exports to the Eurozone rose nearly fourfold in the ten years to 2006. A very crude characterization of the euro might be that the core lent money to the periphery that bought core goods and now the bills have come due.

The reality is that in this environment sides, the core and the periphery (which now seems to be everybody bar Germany and Finland…) are locked in a symbiosis. Coordinated austerity is not going to allow the peripheral nations to grow and in not growing they will neither consume core goods nor indeed repay core credits advanced to stem the losses arising from the credit bubbles or to shore up fiscal ssytems that were not fit for purpose.

The sad reality for Europe is that we have a weak german leader in a strong german economy who for too long was propped up by an even weaker French leader in a weakened france. The European experiment, of which the euro is the latest embellishment, is predicated on france and Germany being strong and democratic and working together to keep each other in check and at peace. In that it has succeeded but the reality now is that to get Europe out of the mess Germany is the only feasible paymaster. It will have to pay in one or more of four ways. First, there is a debate on an arcane interbank settlement system called Target 2. In essence there is nothing to be worried about absent a break in the euro, but were that to happen then Germany would be left with a large hole in the bundesbank. While that might appear problematic it can equally be argued that the net cost would be minor. But that would in any case be unthinkable to the money hawks in the German economic apparatus. A break of the euro would entail the return to the DM, which would result in a massive appreciation, resulting in lower German exports and lower German economic growth. While Germany has shown that it can survive and even thrive with a hard currency the dislocation would be large. Again, a break in the euro would also result in massive losses to German financial institutions, running potentially into hundreds of billions of euro, which would have to be recapitalized by the German taxpayer. The alternative to these is some form of Eurobond (which is constitutionally difficult and politically anathema to Germany) resulting in a rise in German borrowing costs, or a fiscal union including transfers from Germany and eventually France. . The latter in particular would insist that there be tax harmonization in some guise as a condition of entry.

Thus, we face more weeks of high political economy drama and economic highwire acts . Germany and to a lesser extent France need to accept that the costs of saving the Eurozone are going to be (short run and ongoing) high, and weight these against the incalculable disruption and losses of it collapsing. A Greek exit would be in my view an irreparable damage, as it would show that the Eurozone is not a monetary union. For Ireland the question will arise sooner than later: what are we willing to give up to remain in the enhanced European system, or do we take our chances on the outside. The stakes could hardly be higher.

For Europe as a whole and Germany in particular we might do well to recall the words of that most supreme political operative, Cicero , who stated :

“Six mistakes mankind keeps making century after century:
Believing that personal gain is made by crushing others;
Worrying about things that cannot be changed or corrected;
Insisting that a thing is impossible because we cannot accomplish it;
Refusing to set aside trivial preferences;
Neglecting development and refinement of the mind;
Attempting to compel others to believe and live as we do.”

Germany under Merkel has committed most of these follies, insisting that only german management of the economy is the right way (6), that there must be no increase in money supply regardless of the pressing need (4), that Eurobonds or debt monetization are so anathema to them that they are impossible (3), that if only the rest of Europe were German then there would be Germanic economic ordoliberalism prevailing (2) and that we must all simultaneously engage in austerity while exporting to each other (1, 2, 4 and 6).

At least German culture remains as refined as ever. Maybe we should reach into the shared common stock of European culture and recall the words of Voltaire, as echoed by Uncle Ben Parker in Spiderman, who noted that with great power comes great responsibility. It is time that Germany took that responsibility as seriously as its power demands.

Holding my Nose and voting Yes

This is an expanded and linked verison of a column published in the Irish Examiner Saturday 12 may 2012. http://www.irishexaminer.com/business/a-reluctant-yes-voter-for-vital-access-to-funds-193627.html

I have decided, very reluctantly, to vote yes in the upcoming referendum on the fiscal compact. I have previous expressed many many doubts, most of which have remained unanswered. The compact is bad economics, it is inserting an ill-defined and inestimable concept in the constitution, it is highly likely to be a moot compact as soon as a large country deems it domestically expedient to be dropped, and it will result in us having to radically change our way of doing things. The latter may not be a bad thing given how poor at governance we have shown ourselves to be.

The debate has rapidly, and predictably, gone off the rails of the actual debate onto tracks that are only vaguely parallel. It has morphed into a debate on austerity, driven for the most part by the ideologues of the left tapping into an inchoate if understandable desire on all our parts to see an end to austerity. At some levels the debate has been farcical, with Richard Boyd-Barrett claiming that an unspecified 10b (presumably per annum) can be found from “wealth” while at the same time arguing against taxing housing….wealth. The 10b wealth tax meme has been roundly exploded by Seamus Coffey, but as is all too common in Ireland RBB has decided to engage in policy based evidence rather than evidence based policy. At least we are spared so far the more extravagant claims (YES For JOBS) on the yes side but expect the ludicrous level to rise there as the debate intensifies. Another feature of the no side is that it features the same old same old – SF have opposed every single EU referendum since our entry into the EU and one can assemble a DIY ULA Speech from a box of 1982 Socialist Workers Party posters.

The most often repeated argument is that signing to the treaty will institutionalize austerity as we drive towards a 60% debt gdp ratio. This is possible but not necessary. It all comes down to growth . Adopting the fiscal compact will require that in the end the debt to gdp ratio head to 60%. That is a massive fall from where we are now, and many of the commentators, including to some extent myself, see that trajectory as most probably involving a requirement to not simply run small or zero deficits but to actually have surpluses. Underlying the concern that this will institutionalize austerity is is pessimism about growth. The reality is that debt at the national level is rarely paid down. The debt/gdp ratio, the metric that will be used in the fiscal compact era, can fall as a result of debt being paid down (which doesn’t happen), gdp rising, or both. These figures are measured in nominal terms also, so the ratio can be eroded by inflation. An examination of the 1990s onward shows that debt/gdp ratios can fall very quickly.

From 95% in 1992 the ratio had fallen to 53% in 1998. Admittedly the 1990s was an era that in many ways was more benign in terms of the external environment and in terms of the degree of policy maneuver available to government, but the lesson stands: so long as debt does not grow the ratio should fall. It is abundantly clear from the debt-GDP analysis that first, this can can change for good or ill rapidly and second the deterioration since 2007 is appalling, driven by the collapse of the tax base (hence the need to rebalance and re broaden), the collapse of the economy (driven as it was in large part by a credit boom) and by the bales of wet straw that were placed on it by the gargantuan folly that was and is the bailing out of Anglo. The latter is important but it is not by any means the font et origo of our problems. While it may be tempting to call it bank debt treaty (as the superlative Namawinelake has when explaining that that is why he/she/they are agin it) the reality is that 2/3 of the increase in debt since bout 2007 to 2015 in down to our own deficit. It is without a shadow of a doubt true that the bank debt is usurious, that it should never have been loaded on the state, that we have shown ourselves to be singularly unable to gain meaningful change in its repayment and that it is an albatross around our necks. The issue is not that – it is whether or not voting yes or no is more likely to allow us a better negotiation position. As to whether we can effectively use that position is quite another thing.

So we are fine if we get growth but where will that come from? This is the key dilemma for Ireland and for the world. The latest IMF World Economic Outlook is at best cautious on prospects for growth. . We face a period of significant fiscal consolidation through 2015 to simply move to a state where the level of debt stands still. Indeed, at present the plans are still to run a deficit. Structural or otherwise a deficit where debt continues to grow is not conducive to reducing the debt/gdp ratio. The Fiscal council has suggested that additional to the government plans to have fiscal consolidation of 12.4b through 2015 an additional 2.8b might be required to achieve balance. This will weigh on any recovery and regardless of any fiscal corset or compact getting to a broadly balanced budget when the debt-gdp ratios are as high as they are is a good macroeconomic aim.

Nonetheless, as the fiscal compact is specified on nominal levels, so long as we keep debt rising by less than the nominal growth rate we will be reducing the ratio. Given that our average annual nominal growth rates over the longterm have been in and around 10%, achieving even modest nominal GDP growth should be feasible. So long as we do that we will, almost automatically, comply with the headline adjustment figures (see Seamus Coffey again and Karl Whelan on that issue)

A major problem with the plan “going forward” by the government is that it relies in essence on an export led recovery. The entire world seems to now be betting on export led recoveries, which makes sense only if we have found a Martian civilization willing and able to pay for our goods and services. Successive government projections for growth have been shown to be on the optimistic side, and it is clear as a bell that coordinated and prolonged austerity, lite or heavy, in the Eurozone is not going to lead to a recovery and all the evidence is that this is beginning to sink into the political consciousness. Thus at some stage we can reasonably expect some pro growth measures at a European level, whether written into a revised compact or as an addendum. The French and Greek election results guarantee that.

The main reason why I see myself, reluctantly, voting yes is to secure access to funding as and when we need it. The reality is that even if we were not to require a single additional euro of debt, by running a balanced budget, we face a massive refunding requirement. To reiterate, national debt doesn’t get paid off – it gets rolled over and over. Paying off the maturing debt with new debt does this. The trick, as we have noted above, is that with a modest amount of growth the burden on the state falls as a proportion, and with a modest amount of inflation the burden in present day funding terms falls further. The challenge then for Ireland is to achieve this. But we will still have to pay off the debt. We need to repay, to refinance, over €30b between 2014-2018 in national debt, and some 23b in funds issued under the bailout. There is guaranteed funding from the ESM for this. There is the argument that we can apply to the IMF which is true but application is by no means the same as acceptance. The IMF have previously expressed doubts (P 12 here) as to the appropriateness of them sharing the burden alone. The EFSF continuation would also seem to me to provide some cover only for the existing bailout, leaving the remainder of the rollover of national debt and any additional funding to be sought from the markets.

Voting no would thus expose the state to having to fund at least a part of its total requirement from the markets or from internal resources or from the markets at a still usurious price. As States can always fund themselves from internal sources, as a consequence the argument that “they will not let us collapse” do not hold as strongly as did the same argument for restructuring the banking debt. Ireland no longer holds the cards that it did when our banking system was a source of major potential contagion.

Banks reliance on the ECB has fallen and continues to fall, and we now are approaching a percentage of borrowing from the ECB more in line with our economic size. The ECB will support banks (although that support has to be coming to its limits) but they will not and cannot support states. Thus we face a “lesser of two evils” argument : this is pragmatic and economic reality no matter how much it may stick in the craw. Voting No would be the eviler of two lessers, and would rapdly expose how unimportant we now are.

Euro crisis will require some hard choices to be faced.

This is a version of an opinion piece originally published in the Irish Examiner Sat 14 April 2012. See http://www.irishexaminer.com/business/euro-crisis-still-very-much-alive-and-pressing-190499.html.

It hasn’t gone away you know? The Euro crisis? Its back, waxing and waning. Italy struggles to raise money at the short end even with significantly increased rates, and there is event talk now of france being in trouble. To recap: last year the ECB finally began to take action to deal with the acute problems in the sovereign bond market and the banking market, now increasingly and worryingly scrambled together. Through two successive waves of cheap (1% pa) money a massive trillion euro was pumped into the banks. in what was called LTRO – Long-term rollover. Although significantly less in net terms this injection of liquidity (in November and march) was sufficient to significantly cool the sovereign bond markets. It was also a mechanism, as I have noted previously, to allow the banks to begin to fill some holes in their own balance sheets.

Modern economics absolutely needs banks. They are the pumps that drive money and credit around the rest of the system. In Ireland these pumps are broken and we see daily the effects of same. What the ECB has done is quite proper, but in mathematical terms it is necessary but not sufficient. Other factors in the ECB and elsewhere to my mind make this policy less likely to succeed than might be hoped.

First, this approach depends on the banks ultimately passing on their money to productive sectors of the economy. The way in which central bank actions filter into the real economy is one that has been much studied. The bank channel has been the focus of much scrutiny in recent years. The BIS concluded that individual bank capital positions were crucial to their ability to lend on. The also concluded that the key issue was structuring the capital base to allow this to happen. European banks and in particular Spanish banks are not yet fixed. We see in Ireland that the next wave of losses from mortgages is now beginning to consume political and economic capital.

Second, it is in any case treating the symptom not the cause of the problem. European sovereign states display high borrowing costs because of too much debt. The cost of debt is a function of supply and demand; at present there is a lot of cheap liquidity sloshing around which allows banks to purchase this high yielding debt and make a profit. But this exacerbates the issue if states consider that the lowering of bond yields indicates that they can take reform slow. European states are on a tightrope: too much austerity and the economy crashes – this is Greece, where real poverty and want are now rampant, and still the debts are unsustainable. Too little and the markets fear a Greek or worse write-down, this is Portugal or Spain. The circles of austerity-growth-market confidence are unsquarable in my view. We cannot solve too much debt with more debt.

Third there is evidence that the ECB is beginning to adopt a core-periphery approach. In his press conference after the last ECB board meeting Dragi made a number of comments that suggest to me that the ECB board was preparing a Plan B. He restated that where central ECB liquidity operations were not available for banks then domestic central bank liquidity was available. He also reiterated that this was however at the risk (read certainty) of exposure of the domestic sovereign. We have seen this here: despite the best spin that the government has put on it and notwithstanding that there is another game in town with the final settlement of the banks, the brutal reality is that at the end of march this state DID pay 3.1b to the Central Bank of Ireland to pay down ELA which it had advanced to prop up the rotting corpse of Anglo. When the ECB speak of ELA being advanced at local risk this is what they mean. Prop up your banks if you wish but it’s on your own head. Oh, and don’t let them fail. This is a recipe for a Europe populated by Anglo Irish Bank zombie clones. On household (read mortgage) debt overhangs being somehow adjusted (read, written down), The IMF suggests, and the ECB kinda agrees that it should be talked about, but of course the ECB also want us to continue to repay for the ghastly corpse of Anglo (but if he can find some money lads, after that, why not write down a bit of debt)…More recently Jörg Asmussen of the ECB told audiences in Ireland that, in essence, we were on our own with the banking debts.

Fourth, there is a growing theological strain in discourse that debt is not just wrong; it in some ways indicates a moral laxity. Backbench government TDs are increasingly adopting a ‘tullamore housewife’ approach, that government should not spend more than they earn. This of course ignores completely the reality that a state is not a household, and displays a dangerous ignorance of modern macroeconomic reality. At the same time we are being asked to vote on a fiscal compact which will not only in effect ban borrowing but given our debt levels will require us to run cyclical surpluses. That will, inevitably, lead to more austerity.

There are irreconcilable forces beginning to emerge in the European and national debate. At the heart of these lies the ECBs insistence that under no circumstances must banks fail coupled with its abhorrence of any hint of inflation. This is of course counter to the emergent European commission perspective on bank resolution and to the historic reality that debts do get restructured either via inflation or default. Europe will have to choose. There is too much debt. Either it gets written off via inflation, anathema to the Bundesbank , now incarnate as the European Central Bank, or it gets written off in a more or less organised fashion via a Greek style arrangement. The alternative is that the strains on the euro grow, and something breaks. Even now Citibank estimate a 50-50 chance greece will have to exit. Like a seat of flywheels, when one part of the euro breaks off it is highly probable that that a majority of the other parts will fly off also. The German politicians who have then demanded impossible things of the periphery will find the export chickens coming home to roost rather rapidly as their exporters face 30% plus deutche mark appreciation. Then we will see that competitiveness is relative, not absolute.

Just another day in the Irish economy as €1.5bn is paid over by State-owned bank to unsecured, unguaranteed bondholders

Reblogged from NAMA Wine Lake:

Back in antebellum America, it was common for negro slaves to avoid marrying a spouse from the same plantation for a very poignant reason – no man or woman wants to see their beloved raped, humiliated, beaten or whipped before their very eyes, it’s more than can be borne, and for that reason slaves often married slaves from neighbouring or distant plantations to avoid the reality of their powerlessness in protecting their beloved.

Read more… 449 more words

Another day, another bondholder bonanza....

Fiscal Compact Referendum : why I am voting “maybe”….

A number of people over the last while asked me how I intend to vote in the forthcoming referendum on the fiscal compact. At the moment  I am firmly in the I don’t know camp.
I have previously blogged and written about my concerns regarding the fiscal compact. I think we’re being asked to sign up for something which  is in principle a good idea, that is to say it is better for government not to be ill-disciplined with regard to the taxpayers money. There are problems with regards to how we measure some of the key aspects of this proposed fiscal compact, issues around its effectiveness, and concerns as to whether or not it will have an overly large impact upon the bond market.
If we do not sign up for this fiscal contact what happens?
We will not be thrown out of the Euro. No such mechanism exists, and if we can countenance a Eurozone which contains Greece then we can    imagine a Eurozone that contains an  Ireland which is not adhering to the fiscal compact.
Nor will we be thrown out of the European Union.
As things stand at present if we do not adhere to the fiscal compact then we will not be in a position, should we need to, to obtain funds from the proposed European Stability Mechanism.  Of course, obtaining funds from the European stability mechanism is only something that would occur if we required a second bailout, and the government have previously described the notion that we would need such a bailout as ludicrous. So would be signing up to obtain that which we do not need….
There is some question about whether or not not adhering to the fiscal compact would cast doubt on our bona fides in relation to  acting like a financially mature country.  The concern is that if we did not do so then, having to go back to the bond market as we will be doing if we believe the government, we would be facing into higher bond costs than would otherwise be the case. There’s nothing whatsoever to stop the Irish government from putting in place a domestically originated fiscal responsibility Bill. In fact, such an opportunity was presented by the tabling of exactly that Bill by Sen Sean Barrett, which the government declined to support but which to their credit did not vote down. A set of slides explaining the background to the bill and to fiscal rules in general is here.
There will not be a rain of frogs, nor will we see (somewhat contingent on the proposal in item 4) in mass outflow of deposits or a mass outflow of foreign direct investment. These may outflow anyway, but the mere declining to participate in a European fiscal compact (but making it clear that we would pretty much do the things that are  suggested by the compact, although in a more sensible manner)  is in my view unlikely to be the catalyst.
If we do not sign up for the compact then, as noted, we are not able to access the European stability mechanism.  This to my mind is perhaps the only compelling pragmatic reason to consider signing for the compact.  At present the funding under the first bailout extends through the end of 2013.  The intention of the government expressed the number of times is that we will then be “back in the market”, and able to borrow an reasonable terms both to fund our ongoing government deficit and to meet the maturity schedule of existing debt.  It is this issue that seems to be missed by many of the proponents of the no vote who seem to think that in voting no we will escape  austerity. Even on the governments own proposals we will still be running a deficit of approximately 3% of GDP in 2015.  Let’s assume that we decided to close the deficit by 2014, in that case we would have to take an additional €5-€6 billion out of the system over the next three years.  But even if we were to run a balanced budget by 2015 we would still not be of the woods. We face significant repayments of previously borrowed monies from 2014 onwards.

From 2014 to 2020  €30 billion worth of previously borrowed Irish national debt needs to be repaid.  If we are not able to borrow from the European stability mechanism to repay these then we will have to borrow from the bond markets, but in that case we will not, I would submit, be in a position to both borrow for the  maturity of existing debts and for ongoing deficits. In fact, with an ongoing deficit and not adhering to the European fiscal contract we would face very significant interest rates, perhaps in effect locking us out of the markets again, but this time with no European full-back. While it might be possible to borrow from the IMF this is not a guarantee. So if we do not sign up to the compact, cannot borrow from the European stability mechanism, and do not want to face enormous borrowing costs, we would have no choice but to be running a primary budget surplus by 2014. Given the deleterious effect that the existing “austerity” program is having on the economy, politics, and society, we need to ask whether or not imposing perhaps 50% more is either desirable or feasible? In other words, there is no magic relief from austerity. If we do not sign up for the compact then we are in effect going to have to massively accelerate our movement towards a budget surplus. If we do sign up for compact we’re going to commit ourselves to achieving a budget balance, but over a somewhat slower period.

One way in which we could perhaps begin to square this circle might be if we could get some relief on the money borrowed for the Irish banking recapitalization, now masquerading in most part as promissory notes.  Stephen Kinsella, Karl Whelan and yrs truly  spoke at length to the Oireachtas on the whys and wherefores of the Promissory Notes and how to escape the €3.1b anglo-tross which they represent .Unfortunately, once again the government seem to have ruled out any linkage between the promissory notes (approximately  €31 billion) being relieved from Ireland and a vote in favor of the fiscal compact. This morning the Taoiseach said that the Irish voters would not be bribed… I have a very distinct recollection of a previous Taoiseach returning in triumph from Europe weaving a cheque for the then outstandingly large sum of  £8 billion, prior to a referendum.  If it was good enough then to induce the voters to see the in pocket benefits of being on good terms with Europe then why not now?

Presentation to the Oireachtas Committee on Finance 15Feb2012

Below is a version of the written presentation I circulated to members of the Oireachtas Committee on Finance at our discussions today on ELA and Promissory Notes.

ELA is money. It is not a bond. Dealing with ELA does not involve dealing with bondholder although the money so created was used to redeem (pay off) bondholders. The acronym ELA stands for Extraordinary Liquidity Arrangement, and the name of indicates what it is. It is first and foremost extraordinary, in that it is a facility extended to commercial banks by central banks when ordinary (usually taken to be interbank or regular central bank ) short or medium term funding is not available for whatever reason. It is liquidity, in that it is designed to allow a bank to maintain liquidity to its operations and customers, rather than a solvency arrangement, which is designed to ensure that the organization is well capitalized and able to trade in the longer term. It is a basic tenet of corporate finance that we draw a distinction between these two concepts ; solvency, achieved through capital, is a longterm concept while liquidity is a rolling short-term issue. Liquidity crises, for countries or for companies, can arise when lenders no longer have confidence in the solvency of the borrower. This is what happened in September 2008, the initial focus being on the solvency of Anglo and Irish Nationwide (now collectively known as Irish Bank Resolution Corporation, IBRC).

ELA is money. In the normal course of events in the eurosystem money is created under agreed mechanisms. Central Banks have the power to create money ‘by fiat’ that is to say they can create it from nothing. ELA is not part of the normal operation of this monetary creation but is allowed in extraordinary circumstances. ELA is carried as an asset on the balance sheets of the creating central bank, in the case here the Irish central bank. It is not created by borrowing from other central banks. It is not a bond. It is not money loaned to the central bank of Ireland from the ECB, nor money loaned from the other central banks. It is money, as real as any other form of credit agancy. It is pure money creation, by fiat, allowed in exceptional circumstances. As of end-2011 this domestically created money amounted to some €44billion.

How is this money mobilized? When Anglo/INBS became hopeless and obviously insolvent the Irish government recapitalised them. The largest part of this recapitalisation was via the creation by the irish government of a Promissory Note which was issued to the banks. This was not and is not a sovereign bond. We know that it was not and is not as the ECB refused to accept this for normal liquidity operations, forcing Anglo/INBS to instead go to the central bank of ireland and swap this for money which was then used to finance Anglo/INBS, including paying off senior bondholders, paying staff wages, payment of interest on deposits etc. In effect the Central Bank of Ireland monetized the government IOU. The government have agreed to pay off the Promissory Note over a 15 year period. As there is, to put it mildly, considerable doubt as to whether the remaining assets of IBRC are sufficient to generate income to repay its debts the Minister for Finance in March 2010 as well as creating the Promissory Notes also gave (as of this date secret) letters of comfort to the Central Bank (Sole shareholder, the Minister for Finance) promising repayment of the ELA were IBRC unable to repay. Thus the state in effect is indemnifying itself against its own actions. An analogy might be that we borrow from a bank, put that money into a pocket, then move it to another pocket, then take it out and burn it. The effect is the same. Money is destroyed in the same amount as it was created, in order that the european money supply does not increas

How much is this going to cost us? In essence, through the next 15 years the state will repay the promissory note at a rate of approximately €3.1b per annum.

This repayment is treated in the government accounts as a capital expenditure, and can be found in Note 6 of the 2012 estimates as show above. This expenditure cannot therefore be deployed to other, productive, usage. Each year a capital allocation is made for the repayment of these. This capital must be either raised from taxation or borrowed. The true interest issue therefore of the Promissory Note is NOT the implicit interest rate which is paid on them, rather it is the cost of the funds borrowed to, in effect, recapitalize the banks holding the Promissory Notes. Thus seekingconcessions on the interest rate element of the Promissory Note is seeking the wrong concession.

Another issue as to why this matters and why we are paying is that Eurostat decided that as the Promissory Note was irrevocable it was appropriate to treat this as a €31b increase in the national debt, resulting in a world-beating 32% of GDP deficit in 2010. There is no doubt in my mind that the nature of the note and the consequent realization that it was in fact debt played a large part in the slow but inexorable locking out of Ireland from the regular bond markets and the need to become wards of the Troika.

What can be done about this and who can do it? The essence therefore is as follows: the Central Bank of Ireland has created money, outside the normal course of Eurosystem operations for the creation of money. This it is allowed to do under delegated power. However, this delegated power is circumscribed. In effect the ECB council can veto the action of the national central banks when they act in the manner in which the Central Bank of Ireland has done, but only by a 2/3 majority. Thus the presumption is that in general when central banks act to extend ELA they are doing so in a manner that does not interfere with the normal actions of the ECB.

This is where the crux of the matter lies I submit. While the creation of €40b or so of additional money by the central bank of Ireland is small in the context of a Euro area M3 (broad money supply) of €9800b, amounting less than 1/2 of 1%, the ECB has a mandated inflation fighting role. Add to this the historic antipathy of Germany, the dominant power in european monetary affairs, to any form of inflation and we see that the creation of money in this manner is potentially problematic. Were the Central Bank of Ireland not to require the repayment of the ELA, and the writing down of the money supply, this would represent a permanent increase in the monetary base of the Eurozone. 1/2 of 1% is not much but what if other countries were to commence to refinance their banks in this manner? What if in fact countries were to take up a suggestion made that the debtor countries refinance their sovereign debts in this manner? Ireland issues a €X hundred billion promissory note to IBRC, IBRC swaps that at the Central Bank of Ireland for newly created money, the NTMA issue a €X hundred billion bond for 100 years duration at a low interest rate, and IBRC purchases the bond with the real money which the state now has on hand on deposit to fund itself while we restructure the financial and economic system. What if Greece were to do this? Clearly we could quickly find hundreds of billions of ELA created euros being added. This is what is known as monetising the debt and it is anathema to the ECB for reasons of inflation as well as being a de facto breach of the rule that the ECB is not allowed to finance government deficits directly. Such monetary creation is further anathema to countries such as Germany who have in the past suffered episodes of hyperinflation. I would note that at 3% inflation we are far from hyperinflation. European money supply (M3) has remained within a narrow band of €9.2tri to €9.8tri since the middle of 2008 and in recent months has in fact begun to fall sharply again, having fallen heavily (as might be expected) in the   global financial crisis.  We are a long way from inflationary pressures.

It is highly probable that were countries to seek to do this they would find themselves running a real danger of being cut off from further and ongoing liquidity support, might be accused of having the central banks funding the deficit (deficit financing) and be in breach of treaties. Such a move would only be used in extremis but it does show that ELA has the potential for unlimited monetary creation and should be treated as such. It should be noted that we have had experience of a large currency union breakup in the recent past, with the breakup of the Rouble Zone, which zone lasted after the political union of which it was the currency, the Soviet Union.  . Nonetheless, such debt monetisation while a solution to the immediate liquidity problems of countries would in the long term pose a threat of inflation and would not in any case solve the solvency issues of countries or banks and might in the long term pose more problems than it would solve. However, in the here and now …

There are three ways in which we can deal with the cost of the ELA.

1. One is to extend the term of the ELA repayment from 15 years to a much longer period. Extending by 10 times, to 150 years would reduce the annual cost in the same manner. However, we would be ‘stuck’ with IBRC for potentially that period.

2. Another way we could deal with this cost is to simply write the whole issue off. This is NOT burning bondholders, nor is it burning ourselves. However, the consequence of removing the Promissory Note and associated Letters of Comfort might be to render IBRC technically as opposed to functionally dead. IBRC, if we write off the ELA and the associated Promissory Notes, would have remaining assets (loans not transferred to NAMA) and liabilities (some remaining ELA , some ECB loans, a small amount of deposits and some remaining bonds. If after restructuring the balance sheet IBRC is not able to service its liablities then it can and should be wound up. Again this seems to have been ruled our by successive governments and the ECB over the years, despite that it too would be the effect of saving the state the ongoing drain of €3.1b per annum.

3. A third solution would be to seek to defer, to continue in the kicking of the can at which successive governments and european institutions have excelled. We have already received deferment till 2014 of the implicit interest payment on the Promissory Notes, and if such were to be extended for a number of years the strain would be at least be deferred.

All of these however, of which I prefer the second, would require that the ECB accede to this request. The Irish voice on the ECB is not answerable to either this committee nor any organ of government, which is right and proper. It is in my view highly improbable that Governor Honohan has not raised these or similar proposals at the ECB, but the evidence is that so far there is no will from the ECB to allow movement. Why that is remains unclear as it has recently shown willingness to accept heretofore unpalatable actions in regard to Greece. Removing the burden of the Promissory Notes in some manner would only assist the government. It would assist it politically in terms of implementing the needed closing of the gap between state expenditure and taxation and it would assist in base monetary terms. If the Troika wish to have a ‘good example’ of its policies as opposed to a set of ‘horrible warnings’ they could do worse than quietly monetize the Irish banking debt, making clear that this is (at least in principle) a one off and reflects the reality that in doing so they acknowledge the role the Irish taxpayer has played in preventing contagion into the banking bond market in 2008/9.

The fiscal compact: maybe inevitable, hardly sensible

This is an extended version of a column published in the Irish Examiner, Saturday 4 Feb 2012. http://www.examiner.ie/business/business-features/with-our-fiscal-policies-is-the-compact-right-for-ireland-182591.html

The fiscal compact that we have now seen agreed to, the Not Quite an EU treaty as it has been termed, is a curates egg. At one level, like mom, apple pie, puppies and sunshine, its hard to disagree with the lofty notion aspired to, the notion of government finances being run in a coherent, sensible sustainable fashion. But, like the curates egg, it is good and bad. The bad elements to my mind outweigh the good and for that reason, at this stage, it is not at all clear to me that we should take it on board. The government had an opportunity to take on board a (soft) fiscal compact in the form of a private members bill tabled by Senator Sean Barret which would have addressed many of the concerns of the proposed compact without the hard numeric targets. That they did not kill the bill is testimony to the sense of such a rule being required, but that they did not progress the bill shows that there is no urgent will absent threats and cajoling. Had the barrett bill been progressed it would have strengthened the governments hand in that they could have gone to the treaty meetings with a fiscal rule in hand, and which might then have been able to be used as the basis for discussion.

The basic issue that the compact addresses is that all signatory powers must have a binding rule on how much government debt they are allowed to have, and if this is too much (defined as more than 60% of GDP) they will have to reduce it at a rate of 5% of the balance per annum, and to maintain a balanced or surplus budget. This is not sensible economics. It rules out any countercyclical government spending at least until the 60% balance is reached. To a great extent this is the same as the stability and growth pact, whose terms were breached early and often by Germany and France, now insisting that the rest of Europe swallow the medicine they themselves have persistently rejected without demur or sanction.

The basis of modern economic thinking (since 1930) is that governments should in principle be allowed to engage in countercyclical spending, increasing the relative size of government in bad times and shrinking it in good. In effect however this compact is the obverse of the rightly derided McCreevyism of ‘when I have it I spend it’ and takes economic policy back to the early 1920s. That worked well…

Some argue that the terms of the compact are essentially those that we agreed to under the Maastricht treaty and its attendant stability pact. The main difference here with the stability pact is the speed of adjustment which would imply that Ireland would face up to 20 years of austerity followed by an indefinite period of being unable to borrow regardless of fire flood or famine , and the threat. Instead of carrot and stick it is stick and stickier…The threat is that countries that do not adhere to the terms of the compact will not be able to access further aid from Europe after 2013. This of course should not be a problem for Ireland, if we believe the statements coming out of Merrion Street, as we plan to be back borrowing from the markets and thus will not need a second bailout. In fact, Minister Noonan has stated that it is ‘ludicrous’ to suggest otherwise.

Europe as a whole is significantly over the 60% limit. As of 2010 eurostat figures the majority of individual countries are also over. Thus the adoption of the compact suggests a prolonged massive de leveraging of the European sovereign bond market. The euro 17 countries as a whole need to reduce from 85% to 60%. At present terms that is a reduction of some 2.3 trillion euro. That is a massive fiscal drag to pose on Europe. And it will do nothing for growth, rather the opposite.

A further problem with the compact is that if it succeeds it will gravely damage the sovereign bond market. A large (but not overwhelming) stock and flow of relatively low risk assets are required to support pension and investment funds. A shrunken market will be less able to fulfil that role. The fiscal compact states a maximum permissible deficit of 0.5% of GDP. It is easy to work out that with modest growth of say 3% then the deficit rule will result in a long term debt to GDP ratio of below 20%. The fiscal compact therefore requires that over time trillions of euro of assets are removed from consideration of investors. The consequence of this will be an intensified move to safe have assets such as the (to be radically shrunken) German bund market , driving down further German interest rates. Investors will have to accept radically lower long term returns. Alternative investment classes seen as safe havens such as gold, or denominated in currencies such as the Norwegian kroner or Swiss franc will also attract investors, with knockon consequences,

The audi adverts from the 1980’s had the tagline “Vorsprung durch Technik“, or competitive edge gained via technology. This treaty should have the tagline “Vorsprung durch Sparmaßnahmen (vielleicht), or progress through austerity, maybe….There is little doubt that Germany has done very well out of the Euro. The german economic model is one where there are relatively low and stable wages and prices, enabling German companies to maintain their production and prices , the rest of the world becoming more or less competitive around them. German exports to the eruo area stand at approx. 40% of their total exports. This has fluctuated surprisingly little over the last decade. It is not credible but appears to be what we see emerging from Germany that they can wish to have a model whereby the rest of the euro area comits itself to ongoing (and perhaps fruitless ) austerity while simultaneously continuing to buy miele washing machines, BMW’s and so on. What is good for the Eurozone as a whole is good for Germany. But this message, if it is being put across in Germany, is not being made clear.
Ireland is only now beginning to really come to grips with the twin financial problems of the banks and the budget deficit. The drag that the banks will have on the state for the next decade is the role which the Anglo Irish bank promissory notes will play. In essence, to ensure that the exceptional liquidity granted to Anglo via its swapping the promissory notes does not become a permanent increase in money, the Central Bank, acting at the behest of the ECB, is requiring the repayment of same. This amounts to €3.1b per annum for the next decade. The ECB rationale is that if they do not do this here then it will set a bad precedent and could result in money supply increasing and this might, eventually, result in inflation. European inflation now is c 3% per annum. Hyperinflation, which destroyed the economy of Weimar Germany and is alleged as a proximate cause of the rise of Nazi Germany, is generally defined as being rates of c 50% per month. The scarring effects of the Weimar experience still scare the Bundesbank and its successor the ECB. But we are literally orders of magnitude away from this problem. In order to prevent the possibility of hyperinflation in Europe, the Irish taxpayer must engage in a money burning exercise. And we must now, under threat of being cut off from funds, engage in a more rapid deflation of the system than would be deemed optimal. We are being asked to pile austerity on absurdity. At the very minimum the state must seek the removal, in toto, of the Anglo promissory note burden. Then and only then can we see where the true trajectory of Irish fiscal policy might be found, and then and only then can we see if the Fiscal Compact makes sense for Ireland.

Understanding Central Banks….

The crisis has shown us that the role of the Central Bank has rarely been more central to global economic welfare. Calls for more, or less, or faster or slower money growth, for new rounds of quantitative easing, for enhancement of the role of Central Banks as lenders of last resort (but to whom?), discussions on the desirable or undesirable role of inflation…. In this context it is essential for any business to understand what a central bank does and does not do.

Taught by Professor Karl Whelan, who has over a decade worth of experience as a central banker in the Federal Reserve and in the Central Bank of Ireland, this course delivered by my Campus Company will  examine among other issues

• If and if so how central banks influence interest rates and the money supply.
• Lender of last resort operations and banking regulation
• Quantitative easing
• How major central banks are structured, their legal limits and how they communicate (and how to decipher this)
• Liquidity traps
• Sovereign debt and central banks.
• MMT (Modern monetary theory).
• Credit risk in the Eurosystem of central banks and the correct interpretation of movements in payment systems and TARGET2.
• The euro area crisis and scenarios for a euro break-up.

Coming when the global cental banking debate intersects with the role of the ECB/Central Bank of Ireland on the issue of the Anglo Irish Bank Promissory Notes, this course should enlighten and provide business context to these issues.

UPDATE

Karl presented a discussion on exceptional liquidity provisions by the Central Bank of Ireland on Friday 27 January. His slides are

here

.