Crisis? Which one?

Economy | Tue 20 Mar | Author – Business & Finance
Apocalypse by Vasnetsov

Cormac Lucey looks at three inter-linking crises and their implications for Ireland.

The economies of the world are currently beset by three enormous existential crises. Each of these crises is not yet fully visible. But each one has the capacity to unleash enormous financial dislocation across the globe. And each of these crises heavily afflicts Ireland.

The first crisis is the global financial crisis. It came to a head with the September 2008 collapse of Lehman Brothers. There are several roots of this crisis. The global financial system has become too large relative to the “real” economy. Over the last fifty years we have seen the increasing importance of financial markets, financial motives and financial elites in the operation of the economy and our governing institutions. The share of the US financial sector has increased from 2% of GDP after World War II to 8% in recent years.

A key problem is that the financial sector has become too complicated to be readily understood by depositors, investors or even regulators. The 2010 financial statements of a bank with a relatively simple business such as Bank of Ireland are, at 381 pages, terribly long and barely comprehensible.

The growth of structured finance, with its plethora of complicated and often off-balance sheet structures has emerged as one of the critical fault lines of the global financial crisis. So it was that the US authorities permitted a regulated bank (Lehman Brothers) to go bust but intervened to save an unregulated insurance company (AIG) because if it had been allowed fail, the web of guarantees it had issued threatened to bring down large parts of the global financial system.

Ireland too has experienced the full effects of the growth of the financial sector. Ireland now faces a prolonged – and potentially politically destabilising – period of financial deleveraging. The same challenge faces the US and the UK. Very weak economic growth in those states shows that deleveraging is a profound challenge even when a country retains control of its own monetary policy and has a currency which may depreciate.

The Eurozone crisis is the second existential crisis currently engulfing Ireland. While the EU powers that be may have initially comforted themselves that Ireland’s crisis was “three-quarters home-made” (© Professor Patrick Honohan), the reality has slowly dawned on them that the Eurozone faces an existential crisis. How else is one to explain the cascade of crises across the Eurozone periphery from Greece to Italy to Spain to Portugal to Ireland?

While parliamentary scrutiny limits the scope for coordinated fiscal action (and thus the EU-organised rescue funds have proved pitifully inadequate), there is substantial scope for action behind the curtain of central banker independence.  The acute symptoms of the crisis have certainly abated considerably since the ECB, under its new chief Mario Draghi, deployed its own version of quantitative easing last December, the bank’s Long-term Refinancing Operation (LTRO).

On 21 December 2011 the bank instituted a programme of making loans with a term of 3 years and charging 1% interest to European banks. The ECB accepted loans from the portfolio of the banks as collateral. Nearly €0.5 trillion was advanced this way. On 29 February 2012 another LTRO operation took place, bringing the total funding advanced by the ECB this way to over the €1 trillion mark.

Much of the funding released to commercial banks this way was invested in government bonds. Commercial banks must not set aside any scarce equity to invest in government paper. With yields on Irish, Italian and Spanish government debt in the 5-8% range and with the cost of funds at 1%, there is generous interest spread to be garnered on the trade. So, by directly helping the liquidity position of European banks, the ECB has indirectly helped the financial prospects of European sovereigns.

But the ECB is just providing liquidity while Ireland, Italy and Spain face solvency problems.  Time is being bought. But, with faltering economic growth, time is not necessarily on the side of the authorities. With the yield on 10-year Portuguese bonds now at 12.6%, one can buy a Portuguese bond for just 44% of the price of an equivalent German government bond. Portugal is at risk of becoming the new Greece.

The third global crisis is a root cause of the financial problems facing several countries across the globe. This is the crisis of social democracy. Whether it is the UK, the US, Japan or troubled states of the EU, a fundamental question has arisen as to whether the social democratic model of government is financeable. Profound questions have been raised about the debt sustainability of public finances in the aforementioned countries.

And that’s before we include off-balance sheet liabilities such as public pension obligations. A 2009 study commissioned by the ECB and carried out by the Research Centre for Generational Contracts of Freiburg University. The report estimated the liabilities of several countries (but excluded Ireland). So, while Frau Merkel is upset at countries taking on public debt that exceeds 60% of GDP, the Freiburg study estimated that unaccrued German pension liabilities amount to 300% of GDP.

The Chinese curse “may you live in interesting times”, never look so apt.