Saturday, November 27, 2010

More on the Celtic crisis

Paul Krugman makes an interesting comparison between the relative paths adopted by Iceland and Ireland when faced with similar financial crises. He describes the relative success, till now, of Iceland and the disaster looming on Ireland, as the triumph of heterodoxy over orthodoxy in economic policy making.

In both cases, the crisis could be traced to irresponsible lending by banks and borrowing by real estate and other businesses. And businesses and borrowers in both ran up massive amounts of external debts. When faced with their respective decision-moments, the responses could not have been starker.

Nearly 18 months back, Iceland responded by making "foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts". The result was a number of private sector bankruptcies, which also "led to a marked decline in external debt". It also introduced capital controls to prevent sudden capital flight by foreign and domestic investors. It refrained from destabilizing its Nordic social welfare model with the standard fiscal austerity measures like spending cuts.

In contrast, faced with the prospect of huge losses for banks and their irresponsible foreign lenders, the "Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations". The result is that the debts got transferred from the banks to the Irish Government's balance sheet. At the first signs of trouble, it imposed a series of "savage fiscal austerity" measures in order to restore "market confidence". And followed it with more doses of the austerity medicine.

The "confidence fairy" has responded in the most unexpected manner to the actions of both governments. If the supporters of the "confidence fairy" hypothesis were correct, Iceland should have been ravaged by the bond-vigilantes and Ireland should have been ovewhelmed by a rush in market confidence. The results have been exactly the opposite. The bond markets continue to savage Ireland, whose bond yields and CDS spreads continue to rise steeply despite nearly three years of austerity. However, Iceland has made a smart recovery, both its economy and the financial markets, winning praise from even the IMF.

Its CDS spreads have fallen from 800 to less than 300, whereas Ireland's cost of insuring debt has risen precipitously from less than 200 to over 500 points.



In fact, a testament of its success and the problems of the EU peripheral economies is the fact that Iceland's CDS spreads have fallen below that of even Spain.



And, unlike Ireland, being out of the single currency zone meant that Iceland could indulge in significant currency devaluation to increase the competitiveness of its exports.

In this context, Simon Johnson points to the odds stacked against Ireland being able to emerge out of its debts any time in the foreseeable future. He points to the fact the fact that atleast 20% of Irish GDP is from 'ghost corporations', attracted by Ireland's 12.5% corporate tax rate, that have little or no real activity in Ireland. This effectively means that the real debt burden of Ireland is more than 100% of the GNP and could rise to 150% of GNP in the next few years.

The steep fiscal contraction by way of spending cuts, especially at a time when the economy is set to contract for the third year in a row, will amplify the real debt burden. In the absence of a national currency, it cannot even devalue and increase the competitiveness of its exports. And given the extraordinary rise in asset valuations - property prices rose four times - any chances of asset prices rising to reduce the real debt burden is remote.

Further, this year, the government will run a deficit of 15% GNP, and with nominal GNP falling, it could well remain that high next year, even if the government cuts spending by the 2 to 3% of GNP currently envisaged. In other words, Irish economy would have to grow at close to its highest ever growth rates just to ensure that its debt share stays the same.

In the circumstances, it is certain that Ireland cannot resolve its debt crisis without some form of debt restructuring that forces lenders to take substantial haircuts. But coming in the way of this is the significant exposures of European banks to Irish debt.

It is estimated that the claims of foreign banks on Ireland are at over $500 billion. German banks are owed $139 billion, which is 4.2% of German GDP British banks are owed $131 billion, or about 5% of Great Britain’s GDP, French banks are owed $43.5 billion, which is approaching 2% of French GDP, and Belgian banks are owed $29 bn, or 5% of its GDP. None of these countries are likely to support measures that would effectively force their own banks to take losses on their Irish exposures.

Update 1 (29/11/2010)
Ireland becomes the second country after Greece within the Eurozone to accept a bailout. The 85 billion euro ($112 billion) bailout plan, at an average interest rate of 5.83% (compared Ireland's 10 year bond rate of close to 10%), includes a contribution of 17.5 billion euros by the Irish government itself through money it has already raised. Of the rest, 22.5 billion euros will come from the International Monetary Fund. The remaining 45 billion euros will come from bilateral loans from European nations and two European Union rescue funds set up in the spring.

Of this €10 billion will be used to immediately to recapitalise the banks to bring them up to a core tier 1 capital ratio of 12%, with a €25 billion contingency. The remaining €50 billion will be used to meet the budgetary requirements of the State. Under the Plan, Ireland will reduce its budget deficit to 3% of GDP by 2015.

Update 2 (3/12/2010)
Barry Eichengreen has the best article on the prospects for the Irish economy. It is in one word - brilliant!

2 comments:

KP said...

Dear Gulzar,
An interesting article that highlights one of the many failures of the prevailing economic model, built on economic truisms. A large part of the problem is also the narrowing gap in the competitive strategies between countries, that is fuelling tech and asset based boom and busts.
From labor arbitrage and cheap sourcing of material to outsourcing human skills – finally, smaller / less varied economies are now using the strategy of tax arbitrages – possibly, the most non-value adding of all financial tools that nations use, to offer competitive propositions to capital.
Financial engineering and a model that posits the financial sector as efficient allocators of capital - has been the ruin of economies.
The Financial sector (Wall St) is now largely “self-referential” with disproportionate income to social good.
http://www.newyorker.com/reporting/2010/11/29/101129fa_fact_cassidy

The outsourcing of manufacturing produced large gains for the US through the power of brands. But has it outsourced away its competitive edge? (w.r.t manufacturing).
http://blogs.hbr.org/hbr/restoring-american-competitiveness/2009/10/the-us-is-outsourcing-away-its.html

The oft repeated premise of globalization is – loss of jobs in an economy through outsourcing (US) is replaced by value added jobs. While this was true to an extent for the US in the first wave of outsourcing manufacturing jobs – the replacement effects are not proportional and structural adjustments rarely ensure that the losers gain from ensuing advantages.

In the knowledge/Innovation economy – this model is being tested, even more dramatically

That leaves the financial bastion as one which gives advanced economies an inherent advantage with which to advance and retain the overarching lead they possess –as other competitive advantages are diffused and rapidly leveling off.

So, while capital searches for opportunities to maximize returns -we are left with a series of bubbles in the technology sector and asset bubbles in the real estate sector. It is for economists to study if this wave of beggaring economies - is the process of creating a new equilibrium that lifts a whole lot of backward economies.

Countries like Singapore and China, whose systems are referred to, dismissively, as state capitalism, have thrived through the pragmatic and realistic direction of money to ensure better utilization, rather than leave its movement to the vagaries of a market (model) that believes money’s natural flow to its maximization implies social good.

But, the lesson for India’s politicians / planners will be
1. To not get carried away by economists (and economic models) who suffer no disastrous downside on the failure of their models (and definitely not columnists like Friedman who are purveyors of trends)
2. To ensure that we create models that do not skew reward to speculators – and in a world treating humans (labor) as a commoditized resource, balance rewards equitably.
Unquestioned faith in the prevailing market model, the relentless homogenization of our politics / culture, and an education that leaves us with little appreciation of our culture - could leave countries like India looking less and less like the mighty diverse civilization it was – to a cheap “Potemkin clone” of an advanced economy.
So while globalization shifts a little prosperity to larger swathes of the world, let us not forget that the advanced industrialized nations still possess an almost unassailable lead, amusingly, by virtue of the lead they already possess.

Since this is all about models, here’s a quote from Lord Adair Turner Chairman of the FSA, UK,
“Financial innovation . . . may in some ways and under some circumstances foster economic value creation, but that needs to be illustrated at the level of specific effects: it cannot be asserted a priori”

While there are no perfect solutions, we may want to evaluate all economic models, less through dogma, and more by its specific effects.
regards, KP.

gulzar said...

thanks KP. I agree that competition has become more intense now. so the principles of comparative advantage and moving up the value-chain is more relevant now.

and in this dynamics, if the pace of outsourcing is more than the extent of value-added job creation, then the the US economy will have to resolve that. i am personally not in agreement with the line of reasoning. i feel that structural adjustments and re-allocation across sectors/movement up the value-chain will finally accommodate the jobs lost.

your reasoning is that capital is searching for opportunities and in the absence of adequate remunerative options, they are flooding the financial markets (mis-allocated to there). i agree, but it has to do with the macro-conditions. one, the extraordinary monetary accommodation has left too much money sloshing around - the challenge is to use more micro-founded regulatory tools (sectoral credit controls etc) to prevent mis-allocations and bubbles. two, there is a recession and businesses are left with capital that they are reluctant to invest in new capex and expansions. three, prevailing uncertainty means that even the emerging markets are perceived as not as safe as they were five years back.

we should not forget the fact that all recessions are characterized by similar miserable macroeconomic conditions, and this one is a really deep one and recovery is not possible without addressing several other more important distortions/failures, including correcting financial market excesses.

unlike capital, technology, and labor, tax arbitrage opportunities are not controlled by any national or international regulations.

i completely agree with your views on models and its relevance for our policy-makers. we have two problems - imitation of prevailing western models, and inertia to cast away these models even after they have done so in the west.