Sunday, November 7, 2010

Looming Crisis

Things are not looking good at present in Ireland with an enforced economic bailout from the EU/IMF Stability Facility in the new year looking ever more likely.

Unfortunately the damage already done to the economy during the totally reckless latter phases of the Celtic Tiger has been so great that in truth it is hard to see how any credible response can now be made to deal with the financial implications.

As I had always feared, losses from the banking system have been much greater than recognised.
Indeed I suspected that the government was engaging in an unconvincing game of bluff in hiding the extent of such losses. From an initial position that the banks "would cost us nothing" it is now admitted that the losses will be in the order of € 50 bl. (which unfortunately is likely to be a severe underestimate). The projections with respect to property prices on which these figures were made were far too optimistic. Furthermore there is a considerable amount of - yet - unrecognised debt in the banking system relating to mortgages and other loans which represent yet another important aspect of an enormous financial problem.

Effectively therefore our banking system remains on life support and is being almost entirely funded though ECB borrowings.


On top of this despite a severe budget last year, no real improvement has taken place in the budgetary position of the Government. Even with all the banking debt excluded, the current deficit stands at about 12% GDP. With a commitment to get this down to 3% by 2014 this requires that even more severe adjustments will need to be attempted over the coming years. So the Government is trying to reduce the gap by a massive €6 bl. in the forthcoming budget (mostly through expenditure cuts). However for this to have any hope of success, several assumptions (e.g. projected growth in the economy) will need to be realised which do not seem to me at all realistic.


So even if the Government succeeds in overcoming the considerable political difficulties in getting its budget passed in December, it is very likely that the downward scale of adjustment required will erode any chance of economic recovery in the short-term. If this scenario is proven correct then the revenue side will further deteriorate in 2011 so that we could be facing a largely similar gap in the finances next year.


Meanwhile the bond markets already have made this judgement so that interest rates on longer term issues have risen to nearly 8%. And quite simply if such rates continue it is not tenable for the Government to borrow from the market!

However perhaps there is one little chink of light remaining. Given that Greece has already been forced into a bailout and that there are other Euro economies such as Portugal and Spain also suffering major financial difficulties, the EU will be extremely reluctant to accept that yet another country requires an "official" rescue. Acceding to such an outcome could hasten the end of the whole Euro experiment! Therefore everything possible may be done behind the scenes to actually help Ireland financially (without resort to the Stability Facility).

As I suspect that the very targets (and broad strategy) of the forthcoming Budget have been effectively decided by EU officials, therefore a measure of responsibility falls on them to see that they can be successfully realised.

So in a very real sense Ireland has already handed over a considerable amount of sovereignty to the EU and this process is likely to be intensified in future years (even without formal recourse to a bailout).


However this does raise very interesting questions with respect to economic management.

1) Given the nature of our political system with the petty in-fighting that is so typical of our political parties. it seems that we cannot agree on a coherent overall strategy unless it is enforced by the EU. We already have a precedent for this as the Maastrict criteria laid then in the 90's as a condition for entry to the Eurozone greatly assisted in attainment of financial discipline at that time.


2) As a member of a viable Eurozone, a considerable amount of economic sovereignty would need to be ceded in any case.
Though this has happened immediately with respect to monetary policy we still believed that somehow we could keep control of our fiscal affairs. However the very logic of what has now happened would suggest that overall control of fiscal policy in the Eurozone needs to be conducted at a central level.

Not surprisingly therefore the Germans - who see themselves as the ultimate paymasters - are already suggesting conditions for future bailouts that would significantly erode national sovereignty.

In the case of Ireland these problems are considerably magnified by the fact that we one of the most open economies of the world (with the great bulk of our exports relating to multinational firms).

On a more general note as global interdependence with respect to finance and economic activity increases, the traditional model of taking key decisions at a national level makes less and less sense. Though larger nations will still dominate with respect to influence, smaller nations like Ireland will have to become ever more realistic regarding the inevitable erosion of real power.


3) Despite our present difficulties I still think that the penny has not really dropped as to the highly artificial nature of Irish economic activity.
Though the property bubble has indeed been exposed, a potentially bigger issue relates to the manner in which multinational companies dominate our economic landscape.

This can be highlighted by an interesting statistic.
It now seems that Ireland has risen to no. 9 in the World with respect to the value of export services (which is the fastest rising component internationally of trade). For a small economy of 4.5 ml. inhabitants this does indeed seem highly impressive!
However about 90% of the value of these services relates to the multinationals and when one examines further, a considerable proportion can be attributed to dubious activities with respect to income diversion for tax purposes. To put it bluntly much of our export sales do not in fact originate in Ireland! However we are still happy to turn a blind eye to this fact (and of course the tax loop holes that make it all possible).

In fact the vast bulk of employment in Ireland relates to the generation of domestically produced services (which are very much overpriced). So if one shops in a supermarket in Ireland one can expect to pay about 25% more (than the average EU price). Likewise if one goes to a car dealer, a dentist, a pharmacist, seeks childcare or eats out in a restaurant one is likely to pay well over the odds. Of course providers of such services will immediately counter that their costs are very high (though in some cases this is used to justify excess profit margins)! But this only underscores my general point regarding the uncompetitive nature of the local indigenous economy! And lack of value is even more pronounced with respect to many publicly provided services. For example in the health sector, the law of diminishing returns has been operating for some time with a vengeance. Therefore despite a huge increase in employment over the past 10 years there is little evidence of an overall improvement in service.

The root problem goes back to the days when the public sector was used to provide employment (which was not available in the private sector). Not surprisingly a whole set of practices were then built up that were not based on the need to promote efficiency. And then with these now well-established (and vigorously defended by powerful public sector unions) it becomes extremely difficult to make effective changes.


Much as I hate to admit this, it may even be necessary that the radical changes required be enforced from an outside agency (such as the EU Commission or IMF) for the urgent action now required is unlikely to materialise from within our present partnership type model.

So to conclude the bulk of employment in the Irish economy relates to over priced goods and services which we buy from and sell to each other in the domestic economy.
We thus have an opportunity therefore during the next few years to get to grips with a fundamental weakness (which is the serious lack of competitiveness with respect to the indigenous economy).

And if we cannot do this voluntarily ourselves then we cannot really complain if eventually such changes have to be enforced on us from outside.

The Celtic Tiger was a period of great illusion in Ireland. Part of this illusion is being slowly stripped away (in the shape of the property bubble). However we are still in considerable denial as regards the bigger part i.e. reliance on multinational activity built on artificial tax advantages that are effectively exploited here due to a - deliberate - lack of regulatory discipline.

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