Tuesday, 31 January 2012

It's not the Economy, it's the Economics - How all our Politicians don't understand the Problem

No one should be surprised that Enda Kenny has now blamed a collective psychosis for our economic crash. Since 2008 politicians have wrestled with an explanation of what happened to Ireland with all the intellectual alacrity of brain dead rabbits and the explanation has defeated them.

Cowen blamed Lehman Brothers, the Greens (remember them, stupid, smug & out of touch?) blamed too much planning permission, and now for Kenny it is greed and madness. This is the level of analysis at which our politicians operate: wilfully ignorant & woefully uninformed. Terrifyingly there are citizens who should know better agreeing with these various hare-brained explanations.

"Greedy capitalists get money by trade. Good liberals steal it." David Friedman

"Greed" has been used over & over as both an explanation & a denunciation by statist clowns who believe that building houses is properly the business of the government: men who risked ,money, employed others, paid massive taxes (stamp, capital, vat & paye) were just evil. Now it has become fashionable to heap any abuse on them. Such contumely has taken the place of analysis & knowledge.

Neither Cowen's defence of his destructive tenure at Finance nor Gormley & Co's sheer ignorance of basic economics now matter: they have left the stage. It does matter that Enda Kenny is still parroting the tripe that socialist adolescents tell each other in the dark: he is Taoiseach.

Kenny's statement is a direct repudiation of intelligible human action, of knowledge itself. If what happened was a collective out break of madness then it could happen anywhere, at any time, no country would ever be safe. Policy,interest rates, taxation, currency  have nothing to do with what happens in the economy. Economies are thus mere random collection of events powered by uninfluenceable factors over which we have no control. Anyone silly enough to be studying economics should switch to psychology or psychiatry, disciplines which might have some chance of shedding light on the crash mystery. They might even, if we were to pay heed to politicians, try a course at Hogwarts.

The mystery is why there is a mystery. What happened was economics, economics as a branch of human behaviour. Analyse the boom if you want to know the bust.

Dr Patrick Honohan, now the Governor of The Central Bank, did this succinctly in May 2009 publication "What Went Wrong":
"An unsustainable decade-long property price and construction boom, which began before that of the US and UK and went further than these both in price and quantity, had taken over from exports as the main driver of Irish growth. Initially prompted by the increased household formation (related to unprecedented levels of net immigration) and by the sharp fall in interest rates that accompanied the transition to EMU membership, the property boom was increasingly financed after 2003 with foreign borrowing by the banks."

Dr Honahan of course pulled his punches on the Euro: it would not do to have a Central Bank Governor diss the Holy Project. Despite that punch-pulling it is clear NONE of what he outlined could have gone on for as long or been as damaging if not for the Ireland joining the Euro/EMU. The Central Bank was deprived of the only weapon it had, interest rate changes, & the lack of exchange rate risks made Ireland an easy haven for vast amounts of (mainly German?) euro bonds.

"Among the triggers for the property bubble was the sharp fall in interest rates following euro membership: within the euro zone also the disciplines of the market which had traditionally served as warning signs of excess were muted. Lacking these prompts, Irish policymakers neglected the basics of public finance, wage policy and bank regulation." (Honohan p1)

There is nothing mad or greedy in investing in the highest yield products: the flooding of the Irish market with credit made housing just that. This bubble was not driven by Greenspan's "irrational exuberance" ( a remark betraying such imbecilic ignorance should have seen him sacked instead of deified) but by monetary inflation provided by the Irish banks. Flooding the market with cheap money confuses the price signals and makes correct investment decisions impossible. In an inflating market this impossibillity applies as much to the lender as the borrower.(Austrian economists have been pointing out the form, shape & causes of bubbles for at least a century.)

Anglo Irish Bank was central to this inflation. Operating (effectively) without regulation, with interest rates set by the ECB to revive a German economy suffering the hangover effects of the crazy decisions taken during unification (one to one parity between Ost & Deutsche Mark for instance), Anglo was not growing but exploding during that period and that explosive growth was based on property loans. Between 1998 & 2007 Anglo grew its book assets by over 2200% & its profits by over 2700%.(AB Annual reports 98-07) These figures ( a year on year growth of 45%) should have rattled regulators. Instead, in a classic case of "regulatory capture" when the emerging rumours about Anglo's huge exposure to the collapsing property market caused a massive collapse in the banks share price on St Patricks Day 2008, the regulator, Patrick Neary instigated an investigation into stockbrokers.

In the Words of Peter Nyberg:
"Anglo in particular was widely admired domestically and abroad and lauded (by many investors,consultants, analysts, rating agencies and the media) as a role model for other Irish banks to emulate." From consultants Oliver Wyeman to stock broker (now TD) Shane Ross Anglo were seen as the shining light of the new paradigm. Under pressure from such cheerleaders & shareholders concerned about comparative profitability, where Anglo led, the other Irish banks followed.

Lending for property became the business of all Irish banks

Bank lending was growing at a tremendous pace:
"...rising from a stock of €120bn in 2000 to almost €400bn by 2007. The three years ending in 2006 marked the highest sub-period of sustained growth, with loan assets more than doubling overall, growing at a compound rate of almost 28% per annum. This rate of growth significantly outpaced growth
in Gross Domestic Product (GDP). By the end of 2007, total loans and advances to customers
stood at over twice GDP, up from 1.1 times GDP in 2000." (Nyberg Commission p.28) but a shocking 80% of new lending between 2002 &2008 was domestic property related lending .

Banks were loaning money for property with property as collateral: as prices rose more could be borrowed creating a vicious circle of borrowing & asset inflation. The rate of growth in lending out paced deposits so the banks were relying more & more on euro bonds, much of it short term, under the misguided belief that such funds would be permanently available. The rate of growth also outpaced the available sound opportunities for credit leading to a relaxing of standards as banks struggled to for volume in the face of margin-cutting competition.

"This was a plain vanilla property bubble, compounded by exceptional concentrations of lending for purposes related to property – and notably commercial property." (Regling & Watson)

Not only were developers borrowing to build more houses but the very availability of so much credit meant that those buying the houses were paying more every year, despite the huge supply.
 "Amongst the OECD, Irish house price growth between 1995 and 2007, the largest. In real terms, Irish prices grew by 9 per cent per annum over this period, next highest growth rate was 7.6 per cent." (Decomposing Irish house price movements: 2000 - 2010 McCarthy & McQuinn)

The credit bubble was inflating more than asset prices. Average wage increases in Ireland between 1997 & 2008 were two to three times euro-zone averages. The erosion of Ireland's competitiveness should have resulted in a slowdown & unemployment but the inflating credit bubble masked and deferred that eventuality. These economy destroying wage rises were happening both within & without the context of Government sponsored Social Partnership.
Relative unit labour costs (OECD via Regling & Watson p22)



If the banks were bad, the Government was worse. Not content with failing to regulate the banks the Government decided to spend the tax proceeds of the property bubble with the abandon of men who had discovered a Money Tree. In a septic nexus between the Social Partnership Agreements & Bertie Ahern's need to purchase popularity the Government set about cutting taxes while spending more money. Property was paying for everything.

Personal taxes came down as the government became more & more reliant on cyclically sensitive taxes. "There has been more and more dependence on corporation tax, stamp duties and capital gains tax (in that order). These three saw their share in total tax revenues rise steadily from about 8 per cent in 1987 to 30 per cent in 2006 before falling to 27 per cent in 2007 and just 20 per cent as soon as the economy turned down in 2008." (Honohan "What Went Wrong" Page 3)

"In addition, the pattern of tax cuts left revenues increasingly fragile, since they were dependent on taxes driven by the property sector and by high consumer spending." (Regling & Watson)

Between 2001 & 2006 Public sector pay rose by 59% and payroll numbers by 18,000 and between 1996 & 2006 the total bill for public sector pay trebled. During the same ten year period, despite "essentially
full employment for the first time in modern history" (ibid) the Social Welfare bill also trebled.

By 2006 domestic construction accounted for 1 in 5 Irish workers and nearly one quarter of the countries GDP. In that year the price of houses, being built at a rate of twice what could be sold, peaked. Then the credit from the Euro bonds dried up the next year as the US property boom bust.

So the explanation is simple, so simple that it might be learned by heart to prevent more outbreaks of foot-in -mouth:
  • We joined the Euro
  • Interest rates were very low for a long time
  • Awareness of risk was dulled
  • One bank led & the others followed into property funding massive lending not from deposits but euro-bonds
  • A Property Bubble, long, big  & disastrous happened
  • Government spent the proceeds of the bubble property taxes as normal annual income
  • The bubble ended leaving the Government short tax revenue, the banks bankrupt & hundreds of thousands unemployed.

We might well ask, given the appalling failures, what the hell were Government & regulators doing? It was not as if Irish banking was either complicated or innovative:
"Moreover, bank supervisors in Ireland were not called upon to deal with technically complex
problems. Ireland’s banking exuberance indulged in few of the exotic constructs that caused
problems elsewhere."(Regling & Watson) No one was bundling mortgages or playing with complex derivatives.

Everything that happened, the insane asset collateral backed lending, the vast over building, the dependence tax dependence on an unsustainable bubble, all happened in plain sight. Dr Morgan Kelly googled the information that underpinned his horribly accurate 2006 article. There are no excuses for Cowen, Ahern, McCreevy, Neary or Hurley.

For professional, highly paid regulators to have missed what was going on is too shocking.
"Developments in Scandinavia during the early parts of the 1990’s as well as in South-East Asia during the latter half (..of that decade..) should have been well within the professional memory of decision-makers in both banks and public institutions in Ireland during the 2000’s."(Regling & Watson)

We could add to those bank disasters the Savings & Loan debacle in the US which, in its asset-loan-collateral-loan circle the Irish Banking Disaster resembles. None of the reports adequately explains how so much bad banking happened in full view of those paid huge money to make sure it did not.

Follow me on Twitter