Monthly Archives: February 2012

What will solve the jobs crisis?

This is an extended version of an opinion piece published in the Irish Examiner on Saturday 18 May.

The new government jobs initiative is welcome, in so far as it again demonstrates an acknowledgement by them of the seriousness of the employment crisis. Coming less than a year after the last one, we must however wonder if this will be yet another in the seeming never ending series of job initiatives. This one is ambitious: 100,000 jobs will apparently be created within a short time and no less than 200,000 within a short few years, all but solving the employment crisis if we get any hint of growth. And there is an unemployment crisis. 75,000 persons under the age of 25 are on the live register, and all international evidence suggests that the younger and the longer the duration of unemployment a person experiences the greater a negative effect this has on future employability. Of these 75,000 , 27,000 are on the register for more than one year, 2/3 of these being males.

The longterm effects of this experience on this cohort will be very negative, and in my view this is where any jobs initiatives should be targeted first as they are most in need. The standardised rate of unemployment now hovers around 14.5%, and this in the face of renewed emigration. In some parts of the country this crisis is worse than others : with less than 10% of total population the border region has 15% of the live register and a similar percentage of youth unemployment

We have had jobs announced a-plenty in recent years. The may 2011 initiative was short on numbers, but in subsequent disucssions an Taoiseach noted that 100,000 jobs would be ‘a start’. In 2008 the ‘smart green economy’ announced by the then Taoiseach promised ‘thousands’ of jobs in green energy and up to 12,000 jobs in rural areas consequent on a Rural Development Initiative. The Cloud computing initiative in January 2011 had figures in total for up to 20,000 jobs. The proposals here are mainly sensible if sometimes pious. For the most part they are bureaucratic and technocratic in nature, which is in fact a good thing. For the most part, outside direct employment, governments cant really create jobs, but they can create the business, economic and socio-political environment wherein jobs are created. It is difficult to argue with many of the initiatives. Equally it is difficult to see why a government initiative is required to , for example “Identify any sheltered areas of the economy where competition is restricted and commission studies on such areas where appropriate” (1.37) or “Engage with stakeholders on the findings revealed in credit supply and demand surveys with a view to identifying and addressing blockages in the system” (3.35) or “Run a number of business market development ventures, including two significant projects in 2012” (7.4.14). Were all the aspirant actions contained in the document carried through then a start would be made to the transforming of the jobs ecosystem. But then we will have to ask from where the jobs will emerge/

Where are the jobs? A radical transformation of the employment landscape is not easily achieved. The structure of present day employment is therefore a good place to evaluate the ability of jobs to be created. That is not to say that we will not see the emergence of new poles of employment – it is merely to realise that such will start small and take a long time, years or even decades to generate significant employment. At present the structure of employment is heavily weighted to a few sectors.

What is conspicuously missing from the initiative is the largest single driver of employment – economic growth. Growth is noted as the driver, as the engine, as the catalyst, and this is the case. How can we create jobs in an environment where GDP is forecast to grow by anaemic levels . forecasts for GDP range from 0.5% from the central bank, 0.9% the ESRI, 1% the OECD, 1.1% the EU commission, with forecasts racketing lower the more recently they are issued? The bulk of employment , as of q3 2011, nearly 40%, comes from just three sectors. These are manufacturing, trade and health services. Hightech jobs, as defined by Eurostat, account for less than 4% of all employment. Other large sectors include the hospitality sector and education. Thus, any significant growth in jobs will come from these sectors, and they are all dependent on either government spending (constrained) or economic growth in general. There is a weak statistical realtionship btweeen GDP growth and employment growth, weak as there are many many factors involved other than just the measure of GDP, but a simple rule of thumb is that as GDP rises by 1% employment in that quarter rises by 0.1%. Thus sustained and lengthy periods of GDP growth will be required to reduce the overhang. And there is little prospect of such a sustained growth spurt in the next half decade. It is in that context that we need to assess the jobs initiative, and my assessment is that while worthy and useful it is the merest preperation of the ground for a crop yet to be sown.

Brian M Lucey is Professor of Finance at TCD and Managing Director of Ussher Executve Education

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.

(so far 8) questions on the Fiscal Compact which I would like answered..

Following up on my blogpost today and just in time for the sunday business and talking heads shows, some questions spring to mind on the Fiscal Compact. Feel free to pose these to relevant politicians or better yet to answer them below..

  1. How would the existence of the fiscal compact have prevented the Irish economic collapse, given that we would (debt levels apart) have been pretty much within the terms of the criteria? Our problem on the fiscal side was that we were badly balanced in terms of the makeup of the tax base and clientilist in our expenditure.
  2. How exactly will a structural deficit be estimated, given that there is no consistent method for so doing and that it is dependent on in essence a backcast of what the economy might have been at were it growing at capacity? What models and approved by whom will be used to estimate the economic dynamics? What if the ESRI say we are in balance, the ECB say we are not, the OECD say maybe, and the IMF say we might be if their model is right…? Who arbitrates..?
  3. Given that the implied dynamics of the fiscal compact on sovereign debt are that it will radically shrink, what are the knockon effects and how will they be handled in terms of pension and investment funds which will now have to either move to other low risk assets with the danfer of igniting bubbles therein or take more risk with the consequent dangers to pension funding (private and public).?
  4. Would the existence of the FC have prevented the taking on of the bank debts, in 2008, given the effect which that had on the fiscal side? If this is so how can the FC be squared with the evident desire by the ECB to not see banks fail?
  5.  Given that if you exceed the terms of the Fiscal Compact you will be fined up to 0.1% GDP, will that not lead to a exceeding-fine-exceeding spiral?
  6. Given that in general Fiscal policy is taken as the taxation and expenditure elements of government as they interact with the economy, and that this is in essence a state level spending side only treaty, when can we expect common movement on either state level taxation or community level transfer payments to offset the pro cyclicality of this pact ?
  7. If this is ‘a vote on the euro’ what mechanism wil be used to remove us from the euro zone? What treaty, what section?
  8. Given that the government have already stated that the talk of a second bailout (aka being in the ESM) is ‘ludicrous’, and that the only sanction mentioned in the FC is not being able to access same ESM if one does not sign up, what is the downside of saying ‘hmm, no, not quite what we need thanks’?

The fiscal compact: maybe inevitable, hardly sensible

This is an extended version of a column published in the Irish Examiner, Saturday 4 Feb 2012.

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.