Zoning out?

Economy | Wed 3 Aug | Author – Business & Finance
Bank safe from euro sign

The economy is showing some signs of recovery, but the fate of the euro zone and political reform will determine its long-term viability,  writes John Walsh.

What happens next for the Irish economy can only be answered when growth resumes. Debt is forecast to peak at €190 billion, which is roughly 120% of GDP. Of more immediate concern is the budget deficit, which in 2010 was €18.7 billion or just under 12% of GDP. The Government has committed to bringing the budget deficit to within the 3% of GDP ceiling by 2014 stipulated by the growth & stability pact.

The economists Kenneth Rogoff and Carmen Reinhart argue that if an economy is carrying a debt level higher than 100% of GDP, then it chokes growth. This in turn can lead to a debt-deflationary spiral which can have disastrous consequences. Ireland has been in this position before. In 1988, the debt/GDP ratio had reached 135%, yet less than 20 years later, the debt level had been driven down to 25% of GDP on the back of 15 years of robust growth.

But the policy levers that were available back in the early 1990s – a complete liberalisation of the economy – are not an option on this occasion. Moreover,  the global economy was then on the cusp of a major expansion. Ireland became the single biggest destination for US foreign direct investment into Europe.

Now the global economy faces a much more uncertain fate. The west looks as if it will remain mired in a high debt, low-growth cycle for the foreseeable future.

Unlike the other peripheral euro zone countries, the fundamentals of the Irish economy are moving in the right direction. It is regaining the competitiveness it lost during the credit-fuelled property bubble of the noughties. Exports are at buoyant levels and for the first time since 1999 there is a balance of payments current account surplus.
The country is well-positioned in sectors such as life sciences, pharma, alternative energy, greentech, ICT and financial services.

But a number of challenges remain. Domestic consumption remains very weak.

Moreover, access to capital is still a huge problem for indigenous companies. Banks are deleveraging and the alternative forms of funding such as venture capital are still at a very embryonic stage.

The two pillar banks – AIB and Bank of Ireland – are in the process of raising capital needed to meet the tier 1 capital ratios, through a combination of debt liability management exercises and rights issues. The target for AIB is €13.3 billion and €5.2 billion for Bank of Ireland. The Government says that once the banks are capitalised, they will be in a position to lend into the economy.

Capital market and corporate finance activity among Irish companies has been close to dormant for the past three years. To this end, the looming IPO of Irish Life will be watched with keen interest. If that is a success then it could inject some life back in the market.

The strategic investment bank that was much touted by the current government in the run-up to the election will not see the light of day in the lifetime of this parliament. Moreover, Fine Gael’s ‘New Era’ strategic plan which involved heavy investment in infrastructure projects will be hemmed in by the Government’s lack of fiscal autonomy.
But the two most crucial determinants of economic growth over the medium to long term are how events transpire in the euro zone and political reform in this country.

Euro zone

The euro zone faces an existential crisis. The insolvency of the Greek state and the brinkmanship involved between the IMF, ECB, European Commission, Council and the German Government have pushed the crisis to the precipice. At the time of going to print a new €120 billion bailout package had been negotiated, although the IMF was withholding its tranche until the Greek parliament had passed a set of sweeping reforms, including a privatisation programme. If Greece does not receive its first scheduled payment of €12 billion by July, then it will default. The global economy could be in for a ‘minsky moment’ similar to the carnage wreaked in the wake of the collapse of Lehmans.

Could a default presage the break-up of the euro? It would certainly test the political will of the French and German governments. Leading business figures from both countries issued a statement on June 21 urging whatever action necessary to preserve the integrity of the single currency.

But staving off a default in Greece to avoid market convulsions in the short term is much less politically exigent than putting in place the policies needed to ensure the long-term viability of the euro. The current crisis exposes the massive shortcomings in the architecture of the euro zone. There were obviously regulatory malfunctions that contributed to the Irish banking crisis. The decision to introduce the government guarantee in September 2008 led to the insolvency of the State. But for most of the noughties ,there was a massive flow of capital from French and German banks into the Irish property market via the domestic banking system. The ECB is implacably opposed to restructuring this bank debt.
There was some good news on June 20 when it was announced that the funding from the European Stability Mechanism would not enjoy preferred status over other bondholders. That should make it easier for this country to tap the markets in 2012 and beyond. But the multi-billion euro question is can this country get back in the markets?
Flogging Irish Government debt in the future hinges on investors taking the view that the economy can pay down the debt mountain without defaulting and bridge the primary deficit.

Not surprisingly there is a wide divergence of opinion on whether this is possible. Moreover, there is an equally fractious debate on whether continued membership of the single currency is a good or bad thing for the economy. One senior academic, who didn’t want to be named because of the sensitivity of the issue, says: “I think our euro membership has been a disaster. I think it would be easier to get back to budgetary balance if we could devalue the currency.”

Leaving the single currency is legally impossible. But that may change in the future,  says the academic. “If there is a move towards a fiscal union, then that would need a new treaty and a series of referendums across the region. That may create an opening for member states to opt out.

“It really depends on what type of fiscal union is on offer, but if this country was given the choice, then I would say leave. Right now we need a big devaluation to have any chance of making the budgetary adjustment without killing the economy. But that would be up to the Irish people and whether they wanted to pool more sovereignty.”

There is a growing view in the markets that some sort of restructuring of debt among peripheral euro zone countries is inevitable. Mohamed El-Erian, head of Pimco, the largest bond fund in the world, told a press conference on June 22 that it was only a matter of time before Greece defaulted.

But the senior academic says that even if  there was an orderly restructuring of Irish debt orchestrated by the EU, it would not be enough to give the economy the breathing space it needs. “If you restructure, you will save on interest rate payments and that does help, but you still have to bridge primary deficit and that is going to be very deflationary. That is why a devaluation is needed.

“But I think options will become available to the Government in the next year. Some of these options they may not like, so the Government needs to think what its attitude would be if and when they become available. Would we rather go on our own or participate in a fiscal union. That would be the choice and it is a very big one.”

It is unlikely that the euro will survive in its current form and with its current members unless there is some sort of a fiscal union. The complexion of such a union is still up for grabs. One idea being mooted is a bank resolution with the funds needed to support it coming from a tax on the financial system. But that is unlikely to convince the markets that it is comprehensive enough to prevent a debt crisis from flaring in the periphery countries.

Even though a eurobond has been dismissed as unworkable and inappropriate by the German finance minister Wolfgang Schäuble, it would be the most effective short-term measure to shore up the region. A permanent euro zone finance minister with direct control over national budgets is another idea being floated.

But there could be a huge constitutional stumbling block to any resolution.

Given the rising level of anti-euro sentiment in this country in the wake of the austerity programme attached to the €85 billion bailout and the French government’s posturing on the Irish corporate tax rate, it would be very hard to pass any EU treaty needed to advance closer political or fiscal integration.

A very senior corporate financier who this magazine spoke to and who also didn’t want to be named says it is important that Ireland stays inside the euro. “Since the bank stress tests were released in March, the view of Ireland has changed. Some of the biggest private equity firms – KKR, Blackstone – are taking a look at Ireland and are taking the view that it has turned the corner. But there is a huge proviso in this assumption and that is the country does not default.”

Even if the country were to embark on an orderly restructuring of debt co-ordinated by the euro zone, it would not be worth it according to the corporate financier. In return there would be a heavy price in terms of giving up autonomy over tax and other sensitive competencies.

“The figure of €190 billion is assuming the State is fully liable for the balance sheets and off-balance sheets of the banks. The nationalised banks will be privatised again within a number of years and they will not be privatised with totally clean balance sheets. Banks carry big debts on their balance sheets. What we have to clear is the primary deficit and the view among the big international institutional investors is that it is doable. It will be hard but doable.”

Political reform

The arrival of the IMF and EU at Government Buildings on November 29, 2010 to negotiate an €85 billion bailout package surrendered the country’s economic sovereignty. There was much handwringing about the causes of the implosion. The former taoiseach Bertie Ahern put the blame squarely on the international financial market meltdown following the collapse of Lehman Brothers. It was an argument that was used to varying degrees by the last Fianna Fáil-led administration.

There were certainly international factors which led to the credit-fuelled bubble and not least the country’s membership of the euro zone.

But there were domestic factors which led to the economy becoming a protectorate of a series of multilateral institutions. The track record of the last government points to a complete failure of political leadership.

For the first time in the history of the State from the mid-1990s onwards the economy was not mired in recession and anaemic growth. There was a viable model of development, based on a highly competitive economy. But from the start of the noughties a series of disastrous decisions steered the economy towards ruin. As it stands there are no plans to hold an enquiry into the failures of government policy over that period.

If such an enquiry were to be sanctioned, of most interest would be the decision making-process and the interaction between top civil servants and cabinet ministers.

Was this failure of governance down to a complete lack of expertise in these regulatory institutions or was there direct interference from high political office designed to ensure that no measures were taken that would have dampened growth?

There is no doubt that there was a culture of cronyism at the heart of the political establishment that wended its way through Irish businesses and in particular the banking system.

There is the danger that cronyism is so embedded in Irish culture that apart from a few cosmetic reforms introduced in the wake of this crisis, that the stasis in political life will quickly resume.

David Farrell, head of the politics department in UCD, is part of ‘We the Citizens’ movement which is campaigning for political reform. The organisation has been holding assemblies across the country over the past few months.

“We have been getting full houses at these events and there is a real clamour for change,” says Farrell. “One of the things that people are looking for is a radical change to the education system at primary and secondary level and particularly the role of civics. There is an interest in the role citizens need to play as active participants in this society.”
Moreover, Farrell argues that there is a genuine appetite for political reform among the political classes. “We have met with every party leader to discuss this project, all of whom gave positive responses. We had a meeting with Taoiseach and Tánaiste for just under an hour. They didn’t need to have this meeting but they did. My reading of it is there is an appetite for change at all levels.”

Cormac Lucey, a financial analyst and columnist with this magazine, has reservations about the aims of ‘We the Citizens.’ “The big question is do you want more leverage over a politician. What we the citizens are promoting would make it harder for politicians to take a longer term view because voters would have greater sanctions over TDs. I think one of the problems in this country is that we have too much democracy. It is very hard to argue the case against more democracy because the media see it as a good thing. But what are the long-term implications of this. I personally believe in the [Austrian economist/philosopher] Frederick Von Hayek concept of democracy which is that the only real choice voters get is the ability to throw out a government every four or five years. Once you have that sanction, it limits a government’s ability to do bad things.”

But there has been a move to the centre ground in politics over the past two decades. There is very little difference between the mainstream political parties. Voters may have the choice to topple governments at the end of electoral terms, but in most OECD countries, it doesn’t radically alter the political landscape. Lucey is scathing about the “increased professionalisation of politics over the past 20 years.” He argues that there is too much emphasis on focus groups and slick marketing strategies that result in a culture of political expediency rather than coherent ideological and economic philosophies. But possibly the biggest challenge facing the Government in terms of making the economy more competitive is the reform of the civil service. The minister in charge of this brief – Brendan Howlin released an interim report in mid-June. He made a series of recommendations that would yield €238 million in cost-cutting measures.

But Farrell says more far-reaching reforms have to be introduced. He advocates opening up senior civil service positions to outside competition. This would not only improve competitiveness but change the culture of the organisation which is seen as deeply conservative.

Lucey argues that the civil service should run similar to the GE style of management. Individuals would be ranked at year end. Those performing well are promoted, while those underperforming are either demoted or made redundant.  Although he reserves his harshest criticism for the judiciary which he sees as a deeply unresponsive rump, unwilling to reform and the cause of long delays in the legal system which has knock on effects for government efficiency.
“It took 14 years to reach a finding on [former NIB director] Jim Lacey. That is absolutely inexcusable.”