Sunday, 6 December 2009

Transfering public goods to bondholders in zombie banks

Slí Eile: As the pressure mounts on all sides – media, politics, radio phone-in shows – to cut public spending a question arises about the relationship between what is about to happen, on the one hand, and the on-going bailout of banks, on the other. Orthodox commentary pronounces that there is no relationship between two.Following earlier comments by Colm McCarthy Pat McArdle in the Irish Times (26 November) - ‘No silver bullet rescue from fiscal predicament’ – argues that fiscal adjustment has nothing to do with the banking bailout. Call this the Nil hypothesis.

Lets have another look at the Department of Finance Pre-budget Outlook (PBO) and see if any clues are possible.

The core of the Nil Hypothesis is the following two assertions:
The fiscal deficit – defined as the General Government Balance - must be reduced to a level of 3% by an agreed date with the European Union (that being 2014 in the latest round of concessions to Member States that have exceeded their Stability and Growth Pact guidelines).

The recapitalisation of the banks by the Government has nothing to do with fiscal adjustment since any public liabilities or payments in the current period are ‘off balance sheet’ as far as the measure of General Government Balance is concerned.

There is a lot of deft accountancy footwork going on. The Pre-Budget Outlook Table 6 (Technical Budgetary Projections 2009-2010) throws up some interesting but hard-to-explain shifts in spending composition. The estimated or projected General Government Balance appears in the final row of this table and indicates that the GGB says at a level of -12% of GDP. It reads in the text below:

The current Government working forecast, on the basis of a €4 billion adjustment being delivered in the Budget in December, is for an Exchequer Borrowing Requirement of around €19½ billion in 2010 and a General Government Balance of -12 per cent of GDP.

So, a huge adjustment of €4bn (whatever its composition between tax and spending changes) gives no change in the projected GGB – the measure that exercises Government, EU, ‘the markets’ and most journalists.

A lot of pain for a little in return.

The documentation states that the GGB would be -14% ‘without corrective action’. So, Government proposes to take €4bn out of the economy in the first instance (without calculating the negative multiplier effects of this which are addressed elsewhere by notes-on-the-front drawing on ESRI model data) to yield a saving of 2% points of GDP in the GGB.

But, would such a level of adjustment be required if other parts of the budgetary arithmetic were different? McArdle’s key argument is:

‘If the exchequer were to inject another €4 billion capital into Anglo Irish Bank in the morning, this would increase the EBR (Exchequer Borrowing Requirement) by an equivalent amount but would have no impact whatsoever on the GGD (General Government Deficit).’

The reason given by McArdle is:

‘This is because the international rules treat such capitalisation as a “below the line” transaction, ie investment in a commercial State body which is outside the government sector, rather than current expenditure which affects the deficit.’

This is not a convincing line of argument. Surely, the point about not including contributions to the National Pension Reserve Fund(or any other fund from which taxpayers money is ultimately destined for bank recapitalisation) in the GGB measure is not because it will be cycled through some technically private vehicle (a dubious concept and practice, at best) but because the taxpayer is purchasing assets or share-holding (e.g. preferential share-holding) in banks – be they public, private, zombie or other. The theory is that such payments from the exchequer constitute purchases of assets with long-term value and pay-back and should not, thereby count in the GGB. This conforms to international statistical accounting (Eurostat). So far so good. McArdle is right – technically. Payments to the banks via NPFR or other mechanisms are ‘off balance sheet’ and don’t count towards GGB.

However, GGB is not the only criterion of public solvency – nor indeed are all public liabilities necessarily counted in the components of GGB. An example illustrates the point:

In 2009 Government paid €3bn into the NPRF (instead of the normal €1.5bn per annum). This shows up under the Capital Budget in Table 6 of the PBO. The 2010 entry is zero. Why? Presumably (and I am not aware of any public statement to contradict this) the (extraordinary) upfront payment into the NPRF was to replace funds used to recapitalise the banks. If the State’s holding in these banks proves profitable and effective in generating lending, growth and jobs – in the long-run – then this is arguably a good and necessary investment. But, what if a large chunk of the recapitalisation is going into a black hole known as a zombie bank that has no chance of reclaiming large portions of its debt? In that case, the innocent looking payments into the NPFR in 2009 (which will surely need to be repeated again in 2010 and later years if the banks continue to be short of capital) assume a different meaning. Put another way, ‘there is no free lunch’ – there is an economic opportunity cost beside every payment and transaction. €3bn spent this year instead of €1.5bn into the NPRF means that there is €1.5bn less to spend on health or education or social welfare – no matter what the components of EBR or GGB are.

So, McArdle’s ‘Nil hypothesis’ looks most unconvincing and serves to show that the commentariat is too eager to prove a point when it comes to fiscal adjustment. Parking the banking crisis to one side as either ‘being dealt with’ or ‘irrelevant’ to the size of the deficit that matters is not right.

To sum up – there is a lot of non-transparent shifting of funds – embedded into the aggregate pre-budget figures. The scale of it makes the issue of cuts in the public sector pay bill or child benefit cuts pale into relative numerical insignificance. As always, especially during the boom years, eyes were on this year’s figures and next without any consideration of:

* Long-term damage of inflating or deflating the economy at given point in the economic cycle;
* The hidden long-term acquired costs of particular decisions or non-decisions; and
* The inter-connectedness of economic phenomena rendering markets, profit and income flows, tax receipts and spending decisions extremely vulnerable to sudden shocks and unprojected systemic collapses when one card is pulled from the pile.

In other words, we are in the throws of a global crisis of production and consumption based on short-term private greed. Dysfunctional private sector behaviour exacerbated by dysfunctional political institutions and poorly operating regulatory public services are undermining the capacity of national governments and global inter-governmental agencies to restore balance to public, corporate, household and trade balance sheets. The alternatives to this state of affairs will need to be created by future generations. The current generation needs to address the deficit in fairness and hope created by an orthodoxy that worships at the shrine of just one deficit idols.
One thing I will agree with is McArdle’s comment on:

the failure of successive governments to reform our archaic system of budgetary accounting.


Michael Burke said...

This is a very useful post.

Meeting the Maastricht 3% borrowing limit is in any event a needless commitment as it has been historically honoured more in the breach. Currently it is being openly flouted by most Euro Area economies who are more intent on reflation.

The supplementary argument is that the bond market, not the EU commission is the final arbiter of fiscal probity, which is ultimately correct. But for bond investors a Euro is a Euro and borrowing for bank bailouts is certainly 'visible' to them no matter which line it's hidden beneath for accounting purposes.

The issue for bond investors is the risk of default. Which is why borrowing to shore up zombie banks commands a higher risk premium than reflation (which potentially boosts the tax base). In fact French and German benchmark yields have fallen since they announced their (further) reflationary packages, while Ireland's renewal of its unique experiment in contraction has been accompanied by higher relative yields.

Martin O'Dea said...

There is a perpective one might take that would suggest that a government giving billions to a number of banks can be an opportunity.
All of this would probably require an election and can be seen as a challenge for opposition parties.
Could a new arrangement with the beleagured banks, the government and the public not be reached where 20% of individual mortgages are written off; say one property per person up to a value of €1 million. Second properties not counting and the value over €1 million also not counting.

This 20% could be taken from the principle - the term of the loan would be unchanged and the interest rates would not be affected.
Prior to this we would of course need an election and a policy to nationalise the banks temporarily would run and the context of the bank issuing bonds worth €54 billion is relooked at
The bank still gets the €54 billion on its assets - (i have just quickly tried these numbers but) there is 109 billion in outstanding mortgages in Ireland as of 09 (I don't know how much of this would decrease if second third etc mortgages were excluuded but clearly this would lessen the amounts) Taking this as the figure then 20% is €21.92 billion of a write down.

In the new arrangement the banks put €54 billion on its assets of which €32 billion is for property at current value while reamaining €22 acts as a property value adjustment and a fiscal stimulus package in one. The banks cashflow would decrease though perhaps mitigated by reduced foreclosures, also the banks can surely manage their accounts so that this cashflow is not quite as severe as it seems, considering they are still getting a bail out and probably being in the long term in less debt to the govt.

Effectively this would take an average mortgage (again not sure of figures) from €1000 to 800. So we are putting a long term €200 euro extra in everyone's pocket. This would certainly lead to people spending again. While it would be the same if the housing market hadn't been so over charged and everyone would be living in the houses they are living in now - but with the 800 mortgage - the psychological repurcussion is that people would feel they were being given money back or that they could begin to spend. This money, of course, goes back into the economy with its multiplier effect, (the only way we don't continue to deflate)

The hit from all of this in as much as it would be should be taken by the current shareholders. Also we are then telling the people that what the banks did was wrong and that as a government/soceity we are going to be inventive and full of effort in looking after the people and not the banks.

At the conclusion of the mortgages the prinicple amount has a reduced net present value implication. Also the bank has to make reparations to the government at some future point for this bail out - by combining these two things I think there may be a means by which the impact of all of this is best managed and assuage the damage done to the institutions themselves. (Ultimately though if some have to fall they have to fall, in the new landscape we design)
Another thing of note I feel is the fact that this would undoubtedly lead to fewer defaults, which in the end would help the banks as well as the general economy etc.
This fits into the feeling that something is just fundamentally wrong with NAMA as is - as Paul Krugman points out there simply has to be a moral hazard in business and banking - you cannot expect that banks being assisted as is at the moment will not lead to similar or worse behaviour in the future. Truly, what has changed thus far?