Sunday, January 11, 2009

The Elephant In The Room

Economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse. Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions.
Milton Friedman and Anna Schwartz
We won't have an economic recovery in Ireland until the banks are sorted. All bets are off with regard to Government borrowing, private investment and economic growth until then. But like the proverbial elephant in the room, it is the issue that keeps being ignored by many commentators on Ireland's economic prospects. Even the Government appears to be in denial about it. In a curious, 11 page Addendum to the Stability Programme Update last week, the Government set out its view on how bad things are going to get over the next five years. The table above is from page 10. It shows the General Government Debt to GDP ratio rising from 40% last year (and 25% in 2007) to over 66% in 2012. A seemingly open (and widely welcome) admission of the need for government borrowing (and spending) to make up some of the shortfall in aggregate demand in the economy.

The problem is, the banks are missing from the picture. And people are starting to notice, including the international rating agencies. Here's Standard and Poor's explanation last Friday for downgrading its outlook on the Republic of Ireland from stable to negative:
We note that the government has also extended guarantees to seven domestic credit institutions through Sept. 29, 2010, increasing general government guaranteed debt to an estimated 228% of GDP in 2009. Banking system exposure to the property and construction sector of about one-third of total loans (excluding interbank lending) suggests a high risk of asset deterioration at these institutions.
Hmm ... the Department of Finance says 53%; S&P says 228%. I wonder which one the markets will believe? Actually, we know the answer already: the rate on Irish Government bonds is now higher than those economic power houses: Italy and Portugal. And that's only the start: the world's governments are expected to issue $2,000 billion in bonds this year - it's going to get very crowded for countries like Ireland with, to put it mildly, a high degree of uncertainty about future government indebtedness.

My worry is that we risk an experiment called 'Economic Depression in One Country' even as the rest of the world makes its way to recovery. Why? Without the Irish banks being 'right sized' in terms of their balance sheets and credit ratings, then the normal expansion of lending that accompanies recovery simply won't happen. It gets worse. Normally, borrowing and spending by governments is associated with a multiplier effect: for every euro the Government spends on, say, road building there might be another euro (or two) of additional economic activity created by downstream and ancillary activities etc. The same goes for tax cuts.

But when it comes to government spending on the banks (currently running at €5.5 billion) it is quite possible that the fiscal multiplier is less than one, or even (cover your eyes) negative. For example, if the effect of the Government putting money into the banks is that they prioritise repaying the Government (and loosening the chains of direct control) over normal lending then they might actually lend even less than they would otherwise ... Tyler Cowen's eight reasons why we are in a depression would seem especially apt for Ireland in such circumstances.

All the more reason to sort the banks out quickly. Everything else is whistling in the dark until we do.

1 comment:

  1. Can Brian Cowan make a decision? Any decision. Lets put ice cream and apple tart on one side, and custard and cream on the other.... I think he might starve to death waiting to make the choice.

    The committee he formed to look into the issue might have eaten well however...

    ReplyDelete

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