What's that rising in the (Y)east part III

This is the final section of my biggest blog to date, I hope you have enjoyed the blog thus far and if you are new to this site then you can find part I here and part II here.

We left part II asking what Ireland and it's fellow EU members could do to rest power back from the ever dominant Germans, and their Champion of Austerity, Chancellor Angela Merkel.

The Eurozone crisis has uncovered deep rifts between the various member states, something that the creation of the European project was meant to prevent. At the onset of the crisis, the French and the Germans were considered to be in the strongest negotiating position, however since then the French have been dragged into the mess - were recently downgraded again by S&P - and no longer have the perceived power that they once had. This means Germany stands alone as the power broker in Europe. The other nations are looking after their own vested interests, and are not clubbing together to act as a voice of opposition to Germany's austere policies.

I can't say that I completely disagree with German policy. When the crisis hit, many countries realised that they had been living far beyond their means, mainly because they were able to borrow at very low interest rates thanks to the Euro. Whereas before, banks in Italy would have had to buy pesos to invest in Spanish banks/debt, they now shared a common currency and money flowed freely to where the returns were highest - the booming economies of Ireland and Spain etc. Germany actually began the Euro project in a protracted slump, and as a result of this the ECB set the interest rate at contemporarily low rates. In order to get back to growth in the early noughties, the Germans reformed their economy, they liberalised labour markets - more on this later, broke the unions iron grip and encouraged prudent spending and high savings. These German savings flowed into the rest of the Eurozone, as German banks looked to make a higher return, than was available in Germany. For countries like Ireland and Spain this was equivalent to pouring oil, on a raging bonfire of already cheap money. Money that we now know was largely invested in construction.

When the bubble burst and the collateral damage was being surveyed, it seemed that sensible Germany had escaped most of the pain, while the peripherals were left counting the cost of an almighty party. Suddenly the main source of a countries revenue - construction - had dried up, yet the government spending, that had also risen in the boom years, was as big as ever. Worse yet, the spending was an integral part of the economy and slashing it would lead to even further falls in GDP.

Banks were crippled and had to be bailed out - according to the ECB and by extension Germany - as, lets not forget, a lot of the money that those banks had been lending was actually German cash. Brian Lenihan recounted how the erstwhile president of the ECB, Jean-Claude Trichet, called him up the night that Anglo was saved, and told him that Ireland could not allow the banks to fail, as it could result in the collapse of the European banking system.

So in effect Ireland bailed out Germany.

Apart from the very obvious flaw with this plan - that we %@&&*%$ bailed out Germany - there were some bones of contention.

During the boom, banks made outrageous amounts of profit, and paid their clueless CEOs fantastic sums of money, however when the bust came everyone shared the pain, and the banks became state owned - socialism by any other name. Did the very stupid people running these banks give back some of the money, nope not a single penny, they were put out to pasture and paid more taxpayer money. One could argue that they should all have been jailed, but thats another matter.

All of this inevitably lent to the bailout 2 years later - how ironic - with the Germans leading from the front, in terms of the structure of said bailout, and the terms and conditions that would apply.

In the 2 years between the re-capitalisation of the banks and the Irish bailout, the Germans developed memory loss and forgot, why we were where we were in the first place. They did however remember, that when their economy was in trouble that austerity won out in the end. This therefore was to be the plan for every other struggling European country.

As I mentioned, I don't fault Germany entirely for this course of action. Ireland was spending far too much vis a vis the tax it was taking in. Drastic cuts had to be made to steady the ship. Other reforms were also needed. Ireland's labour laws were already very flexible - employees can be fired and by extension hired quite cheaply, but other  areas did need drastic reform. Areas such as protected professions e.g. lawyers needed to be liberalised and more competition fostered in general. The banks also needed to be cleaned up, and people in negative equity needed to be dealt with. As it turns out very little was done about this in the end.

The troika - as our new paymasters were known - were not satisfied with that however, and they insisted that tax levels were increased across the board. This is an area where I do find fault with German policy. During the bailout the Irish budget was being released to the German parliament, before most Irish politicians got to see it. Germany was a big factor behind the ridiculous rise to 23% of the top rate of VAT, and the 53% top rate of income tax that are still in force today. This has done Ireland no favours and has depressed demand, and led people to emigrate to countries with lower rates of tax. It has oft been said that you can not tax your way out of a recession, this is not strictly true in my opinion, but the amount you can raise from tax without causing further pain is limited. The concept of 23% VAT is a joke considering we have a land border with Northern Ireland - where a weak pound and lower rate of VAT come into play.

Ireland was not alone in facing these demands, Greece has been forced to cut even more savagely. Portugal, Spain, Cyprus and Italy too have had to make growth destroying cuts.

The German's had the advantage of pursuing austerity during a time when their trade partners were booming, and there is no doubt that the pain they went through has paid off in the long run. Prescribing austerity to every other country during a global downturn, has proven to be somewhat effective, it can not and will not end the Euro crisis however.

In part II I looked at other ways that Europe could lessen it's debt pile, and described how a good dose of inflation was required; to devalue the debt; and speed up the recovery. Germany as the most powerful country in Europe has the final say - although technically the ECB controls this - and will not change its ways on a whim. Someone needs to stand up to the Germans, and I feel that Ireland needs to be a part of this.

Ireland is in a strong negotiating position - believe it or not. It has swallowed it's austerity pill, taken the bailout and is now on the verge of an exit, and return to the bond markets. Our small island can be a beacon of hope for other nations, proving that there is a light at the end of the tunnel. This should be our negotiating stance.. the Germans need to be told in no uncertain terms, that they need to loosen their iron grip on the ECB and allow more inflation - quantitive easing, direct buying of government bonds etc. This will allow the likes of Spain and Greece to become competitive once more, and should help to devalue the Euro, giving them an export boost and a well needed shot in the arm. Germany may well complain that the competitiveness issue is not their fault and that reform is the key. There is no more room for reform though, as voters get more and more fed up of austerity.

You might well think at this point - well the ECB have just cut the rate to 0.25%, so surely Germany does not have that much control. You would be right in this regard. The rate of interest is set solely by the ECB, however with this rate already very low the incremental affect of each new cut is minimal. What the ECB really need to do is tear up the rule book and start printing money to really stoke inflation. This is where the German's hold the power, money printing is not allowed under EU law, and as long as Germany opposes this there will be no change here.

Let me explain why inflation will help. In Italy if you want to fire a worker you need to pay them 2 years salary, this means that Italian businesses, will try and hire as few new people as possible and are also unable to cut the people who are now earning too much money, for the work that they do. If inflation were to come in and rise at 2-3%, then the real cost of wages in Italy would conversely, fall by 2-3% per year, until such a point where they were once again in line with productivity. As productivity and wages become aligned, more workers could be hired easing pressure on the government and allowing them to then reform the labour market - they would make firing people a lot easier and cheaper - without having to deal with an already angry - and highly unemployed - electorate. People often talk about how Ireland regained its competitiveness, and we can say that this is thanks to the liberal labour laws in Ireland. People who cost too much were fired and either replaced with cheaper labour or not replaced at all. Archaic as this may sound, it is very important for businesses to be able to cut costs when times are tough.

Germany too has liberal labour laws, but controls its inflation and wage increases very carefully. This has meant that they have been able to continue to export successfully, even within the crisis hit Eurozone, where others have failed. German wages are comparatively very competitive vis a vis Spain and Italy and therefore they can export goods at a lower cost. They also have a very high end manufacturing sector where costs are a less important factor than skills or efficiency.

What needs to be done?

The peripheral nations should band together with the likes of France, and take the fight to Germany. They can reasonably argue that they have done all that they can to fix their economies and now need a boost in competitiveness. To achieve this they need a devalued Euro, inflation and for Germany to boost its domestic consumption i.e. buy more imports and sell less exports. Without these changes there will be no meaningful growth - not in the long term anyway. Growth is key as it reduces unemployment, reduces state spending and brings deficits back under control. Growth will also make the electorate more placid, and allow the less popular reforms to be pushed through, with less opposition from the people.

Should Germany stand defiant, then the peripherals should use the only negotiating chip they have left and threaten to leave the Euro. This if nothing else will make Germany stand up and take note. As we have already discussed a Euro with only the wealthier nations in it, would sky rocket in value. The countries that left however would enjoy greatly devalued currencies and would be able to export at incredibly competitive rates. A holiday in Spain would cost a fraction of today's price and Irish agricultural goods would be able to undercut any other big agri exporting nation. This decision would not be without its costs however, and therefore it would need to be used as a bargaining chip, rather than a giant game of chicken.

One thing is for sure, Germany thinks that this crisis will solve itself and they are wrong. The peripheral's have done as much as can be reasonably expected - while keeping voters onside - and it is now Germany's turn to acknowledge this and give some leeway. The fact that Germany is still in coalition talks makes it unlikely that there will be any announcement in the immediate future, but once the government is formed Merkel needs to reassess her view on Europe.

Conclusion

This blog has covered a lot of different areas, I looked at the last 5/6 years and tried to look at what needs to be done in the future also. A lot of this was done at 10,000 feet and I am aware that I skipped over some of the bigger topics i.e. inflation, costs of defaulting, labour laws and so on. I will try and come back to these individual topics in more detail in future blogs. There is no doubt that I have taken some liberties with my explanations in order to try and limit the length of the articles. Please do feel free to let me know your thoughts on this blog (all three parts). Thanks for sticking with me so far, and I hope you continue to enjoy going forward.

Cheers,

Andrew

What's that rising in the (Y)east? part II

This is part II of this post, if you have not read part I you can find it here

So we left yesterday’s blog asking

1. What if the status quo takes a turn for the worse?

2. Who will pay for any shortfall in capital?

The first question is something that the Irish government doesn’t want to think about. However we can say with 'some certainty' that the Irish property market has 'probably' hit the bottom - or at least, we can cross or fingers and pray that it has. In Dublin the prices are rising again, and nationally we are very close to rock bottom. The drop from the peak has been 50%, but remember, not all houses were bought at the peak, so the value of the houses with mortgages remaining on them – and taken out pre-crash - are in negative equity to the tune of between 0-50%. We can say with some certainty that writing off 50% of the value of Irish loans is a conservative measure – aka is close to a worst case scenario. Hence, the capital against the Irish loans should be sufficient. Yet, what about the British loans? Remember, everyone is assuming that they will not suffer any significant losses.

At the moment the British loans are performing largely as expected, their rates of default are within normal levels and therefore no extra emergency capital is required for them. In London - where I believe the majority of these loans were made – the value of property has risen above pre-crisis levels, meaning there is a good chunk of equity in place as a cushion. This means that if a borrower in London gets in trouble the bank can foreclose and sell the property, without taking a loss on the transaction. This is definitely a positive.

Much of the UK loan book has been put on the block, or will be put on the block in the coming years. As the loans are performing, the banks should recoup the full or close to the full value of the loan, and will be able to walk away without any major loss. Over time then, the Irish banks can shrink their loan books to circa 150 billion, a more sustainable amount.

The problem is that London is in the midst of a rapidly inflating housing market. To some – and Mark Carney the Governor of the Bank of England is not one of these – this is a property bubble pure and simple. David McWilliams - who predicted the Irish crash – had a piece in the Irish Independent recently, where he made the case for this. Credit has risen 6% in the past year alone in the UK, and central London house prices have risen by 11.5% this year, and are forecasted to rise another 8% next year.

This property bubble is unusual in that some people are convinced that it is a bubble and others - mainly the people who are actually buying the houses, as well as most regulators - are convinced that it’s not, or have not factored this into their thinking. Those who are asked about the housing market, say that they feel buying now is a good investment, as they believe prices will only rise in the future. Further to this, the issue of affordabillity has been debated to a large extent in the media, yet seems to have made no impact on the pysche of the people who are buying the properties. No one ever knows when a bubble will burst so this could have some legs in it yet. It may even be that there is no bubble here, yet history would seem to suggest otherwise.

Let's assume that there is a bubble and at some point it will burst. If at this point, the Irish banks are still sitting on 50 billion of UK loans, we will know all about it very very quickly.  The chalice will turn out to be a poison one and guess who will foot the bill?

Well doesn’t that lead me nicely into question 2….Who will pick up the tab for any further capital needed by our banks?

There are essentially 4 and a bit options here

1. The bank raises the extra capital needed on the capital markets - highly unlikely.

2. If one bank is especially exposed to Britain it could be merged with a 'stronger bank' - also highly unlikely as no Irish bank is in a strong enough position to save another.

3. The government steps in again - More likely although there would be massive resistance from the public, the government would probably fall and we would just end up needing another bailout.

4. The European Stability Mechanism (ESM) directly re capitalises the bank(s) and takes a stake in said bank(s), or it puts the burden on the government in what essentially would be another bailout.

As options 1 and 2 are unlikely I will ignore these and look at 3 and 4.

Option 3 - Enda the White Knight

If we are using the same method as we used for the Irish loans, the capital shortfall for the UK would be somewhere in the region of 25 billion. Our national debt currently stands at 200 billion and rising vs a GDP of circa 160 billion. Factoring in another 25 billion - a whopping 15% of GDP - seems like an event that the markets would not take kindly too. Most commentators would tell you that Ireland is on the edge at the current levels of debt, and an extra 25 billion would almost certainly push us over.

Option 4 - Germany, eh I mean Europe to the rescue

If everyone in Europe can agree - highly unlikely given what has gone before - that Ireland can shoulder no more debt, then the Europe wide ESM would have to kick in. This would be deeply unpopular in countries like Germany and Finland where voters are against any sort of debt mutualisation or write down. They may not have any choice however, Ireland has been the poster boy of Europe and of all the countries that have been bailed out, Ireland looks the most likely to succeed. If Ireland were to falter then the likes of Greece, Italy, Spain, Portugal and Cyprus may decide that the pain is no longer worth it, and could in theory decide to leave the Eurozone.

This if nothing else should spur Germany into action. While German voters may not like the thought of sharing the peripheral countries' debt, the other option of a wide scale default would damage Germany to a far greater extent.

If the Eurozone were to break up, there would be another global recession. The value of the Deutsche Mark (DM) - we must assume that the Euro would cease to exist - would shoot through the roof, as investors looked for a safe haven. German exports would grind to a halt due to the recessions in its trading partners, and the prohibitive cost of its goods caused by the very strong DM. Exports, by the way are the driver of the German economy.

The weaker nations however should in theory thrive - after some initial pain - as they would be able to export very competitively, with their new greatly devalued currencies. This is of course theory and other nations like Argentina, who have defaulted before are still feeling the pain, although this is possibly due to political decisions rather than purely economic factors.

Competitiveness is what the peripherals need more than anything else, they lost their competitiveness during the boom years and the only way back for them is to be able to devalue. Devaluation in a monetary union is a painful process - as we have seen - and there is only so much an electorate will take before they start to look to extremist parties. See the rise of Golden Dawn and Syriza in Greece.

There is another option - call it 4 b - which is still unpopular amongst the Germans, but may be the only answer, and the most palatable to all concerned.

This option is inflation. Inflation can - I stress the word can - be a very useful tool as it makes debt smaller in a real sense. If I owe someone 100 euro and inflation runs at 50% then after one year the amount I owe is only worth 66 euro in today's money. Inflation is a more palatable way to reduce your debt burden, although in theory it is a sort of soft default. Currently Eurozone inflation is running at 0.7% which is considerably lower than the 2% that the ECB is mandated to achieve. Most of the trouble countries are used to high inflation, but the Germans detest it, as it caused them huge issues after WWI during the Weimar Republic. The Germans will have to give ground somewhere though, and this looks like the most likely compromise. An added boon would be that inflation would almost certainly run higher in Germany than the rest of Europe, making Germany less competitive and allowing the peripherals to export more to Germany, rather than the Germans exporting to the peripherals as is the current state of affairs.

I should add that Chris Johns in today's Irish Times argued that while inflation is needed, it will not be allowed to happen. He feels that the peripherals will be forced to continue their painful process of devalutaion. I strongly disagree with this point, while Ireland is starting to look somewhat better, the level of unemployment and especially youth unemployment in Greece and Spain at +25% (general) and +50% (youth) will cause tensions to boil over at some point in the not too distant future. Angela Merkel's CDU party has been voted in for another 5 year term and should have a strong mandate to resolve the Euro crisis once and for all. Germany can push so far but they are running out of room and need to look at new ways of adressing the crisis. 

Inflation is not without it's issues and like everything there are pros and cons, I will discuss this in a future blog, in greater detail.

You have probably noticed that the Germans have the final say in most of European policy decisions. In part III I will look at what the rest of Europe and especially Ireland, should do to stand up to Germany, and make the Euro work for everyone and not just the Germans.

What's that rising in the (Y)east?

The Great British Bake-off (GBB) was a celebration of quintessential Britishness; was gripping; elegant and drew a nation together in a crescendo of drama, which climaxed in the final episode, in which somebody won. I wouldn’t know to be honest as I didn’t watch a single second of it, being Irish contrasts somewhat with the quintessential Britishness I described above.

What I have been watching is the other British obsession that is rising like yeast to the East of Ireland. It may not have the same attributes as the GBB but it does or will have all of the drama and will almost certainly end in a climax (probably not a good one). I am talking about the rise of property prices in London; and by extension the UK.

If you are still with me, let me assure you that this will not be another property bubble blog. However the UK property market is a very important aspect of what I will discuss….. and it allowed me create a dramatic opening.

This blog is going to come as a series; I will deal with a number of topics under the same umbrella. By the end of this I hope to have covered, the Irish banking sector, the national debt, the role of Germany in the Eurozone and of course the story in Britain.

The first issue I want to look at is the Irish banking sector.

There are many debates around this sector, specifically regarding how healthy the banks really are - or aren't, as the case may be. Seamus Coffey has taken a detailed look at this on his blog and if you want the detailed number crunching analysis, then you can visit his blog (after reading mine of course) here. For those who chose not to read it let me synopsise.

He says that the current value of loans on the books of the Irish banks is circa 214 billion. This by the way happens to be slightly larger than the Irish national debt, which itself is about 120% of the Irish economy.... a sobering thought. Of these loans about ¼ are loans made to the UK and the rest are loans made in Ireland. Economists have estimated that in a boom such as Ireland experienced it is typical to write off about half of the debt as bad debt. So what does that mean in numbers?

Irish loans are ¾ of 214 billion, which weighs in at 160 billion. Of this approx half will probably never be paid back. So the Irish banks stand to lose in the region of 75-80 billion. As we have already injected 65 billion into the banks - via the government bailout – there is the potential for another 10-15 billion of capital to be provisioned for. Capital by the way is another word for a reserve; a bank needs money to survive as does any business. When I say capital, I mean how much money does the bank have in reserve to pay for any future losses. The government can do some financial trickery to reduce this figure (the 10-15 bn) without actually injecting any more cash. So lets say for now that there is no more capital required, for the next few years at least.

You may wonder why no provision has been made for the UK loans. The reason is that these are largely preforming – getting paid back essentially. At this point one can assume that there will be little or no loss on these...... Watch this space!

So the fact of the matter is that the Irish banks are largely capitalised to a level where they probably can survive. Add to this that the banks are close – or so we are told – to generating a profit again. Therefore one can assume that the, level of capital should right itself over time or, the banks will be able to get any further capital requirements from the markets. Again this is assuming that the status quo remains the same or improves.

But there is a twist in the tail, over the coming year the ECB are going to carry out stress testing of the systematically important banks – banks that can make the whole system go kaput if they go under basically – and as luck would have it, the Irish banks have been included in this assessment. Once the stress tests have taken place, and any capital shortfalls have been identified and dealt with (I’ll come back to this later), the ECB will begin to supervise the banks. This in theory, means that any future bank failures would be paid for by all of Europe and not only the local government. Although this is strongly opposed by the Germans, more on this later.

Seamus Coffey believes that all of the skeletons in the Irish banking closet have been revealed, and does not believe that any further re-capitalisation will be needed following the stress tests.

Of course the best case scenario would be that the status quo gets better, house prices have stabilised and may rise - they already are in Dublin - which may reduce the levels of negative equity, and lead to less of a write down for banks. That in turn would mean less losses and more remaining capital. Banks have also avoided engaging with borrowers to any great extent so far in the crisis, but I feel they will be gradually forced to do so over the coming quarters. By doing so they may be able to work out a payment system where more than 50% is recovered. Some suggestions are that some buyers may be forced to sell and then pay off a pre-agreed amount, which would bring the loss for the bank down to perhaps 35-40%. I am simplifying things somewhat by concentrating only on property - banks of course made loans to consumers, business etc as well - but as this by far makes up the biggest portion of the Irish debt at 117 bn, it is a good barometer for losses.

If we take a more pessimistic look however, there are 2 issues to deal with here.    

1. What if the status quo takes a turn for the worse?

2. Who will pay for any shortfall in capital?

The answers to these questions will be revealed in tomorrow’s blog