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Hair of the Dog?

Michael O’Sullivan

There is a well-known scene in Charles Dickens’s Oliver Twist where Oliver asks Mr Bumble, the poorhouse master, for more gruel (“Please, sir, I want some more.”). Bumble’s response is violent. This scene is increasingly being played out in financial markets, with a twist. Investors are like Oliver Twist, thirsty for more liquidity, though in the old days, central bankers like Arthur Burns, who coined the term “take the punch bowl away”, and Paul Volker were the monetary incarnation of Bumble. In the aftermath of the global financial crisis, however, central bankers have changed their tune and it is not too unkind to characterise their response to demands for liquidity as “How much would you like?” rather than “More?”

This change in reaction function, to put it awkwardly, underlines the fact that the global economic and investment climate are now marked by the emergence of trends, policies and behaviours that would have been seen as radical before the financial crisis but which are now accepted as normal. In particular the presence of central bank liquidity (formally known as quantitative easing or “QE”) is dominant and has the eerie effect of dampening market volatility to record low levels, levelling bond yields and elevating the price of risky assets like high-yield bonds.

Europe has recently succumbed to the mania for central bank liquidity. Following the recent ECB meeting where the central bank announced that it would purchase asset-backed securities, expectations are high that the ECB will embark upon a policy of quantitative easing (buying government bonds) towards the end of this year.

Against this backdrop, the Irish economy is beginning to recover, but there is also a sense that like the early 2000s it is the crucible for the spillovers of many of the forces acting on the world economy. It is unique it in that it has probably benefited from QE in the US, the priming of the UK economy by the Bank of England and now stimulus from the ECB. The risk is that it is now over-drugged, with little will or means to control the side-effects of what the large central banks are doing. In this context we have to question whether QE works at all from an economic point of view, whether it can cure the euro zone and what path will Ireland’s economy take in the next five years?

While if often seems that QE as an economic remedy is ordained by markets, it does have respectable origins. Its contemporary conception has its origins in a speech given in November 2002 by former Federal Reserve chair Ben Bernanke, where he pondered publicly what the central bank might do were it to be confronted with Japanese-style deflation. Bernanke launched the first wave of QE in the immediate aftermath of the financial crisis and it had a generally positive effect, helping to repair capital market dysfunction and to permit banks to remake their balance sheets by raising debt. The second wave had arguably less impact but is seen as having kickstarted a recovery in the US housing market. It is debatable whether the third round has had a decisive macroeconomic impact but it has had a manifest effect on the behaviour of investors to the extent that “central bank liquidity” is widely perceived as the motivating factor for investors internationally.

Unlike the period before the financial crisis, where investors were generally perceived to be complacent about the risks posed by an overdeveloped banking system, there is a lively debate within the financial markets community as to the extent to which prices are driven by the combined effects of QE from the Federal Reserve, the Bank of England and the Bank of Japan. At the same time, it is hard to detect a vigorous debate among the academic economics community as to the risks that QE has engendered. While some professors, such as Jeremy Stein and Martin Feldstein, have prominently highlighted their concerns regarding its side-effects, the overall sense is that relatively few academic economists are challenging the use of something that was initially intended for “nuclear”-type situations, as an everyday policy lever. The Bank for International Settlements has also bravely confronted this issue but as a result has acquired renegade status.

Another side-effect of quantitative easing that requires a louder debate is the impact that the Federal Reserve’s bond-buying has had in increasing wealth inequality. Quantitative easing has inflated the values of real estate, equities and bonds and thereby given an advantage to the very small proportion of capital-rich households and individuals who hold relatively large amounts of these assets. A further puzzle here is the very explicit anchoring of US monetary policy to developments in the lower reaches of the labour market. Normally, American central bankers have tended to balance the goals of supporting economic growth and limiting inflation, but the current chairwoman, Janet Yellen, has departed from the majority of her predecessors in tying the path of interest rates to improvements in long-term unemployment. In many respects this is noble, but it may not be an efficient use of monetary policy given the countervailing risks to asset and consumer prices. Again, relatively few economists have challenged the appropriateness of Yellen’s singular approach.

From a European point of view this must seem odd. Some European countries are practised in dealing with long-term unemployment and the suite of policies that tends to work well, such as early engagement, retraining, provision of supporting services (childcare) is well-documented by bodies like the NESC (National Economic Social Council) in Ireland. In Europe, the problem of long-term unemployment is typically seen as a political one, best solved through microeconomic rather than monetary policy. It may be that the lack of political action and the inadequate nature of federal spending support for the long-term unemployed in the US have led Janet Yellen to believe that she must take up this challenge.

It may well be that Yellen’s preoccupation with resolving structural unemployment stems from a view that the long-run growth rate for the US economy will be lower than the average of previous decades. Indeed, there is a gathering policy debate as to whether the trend growth rate of the world economy is going to be stuck at a historically low level for quite some time. This “secular stagnation” school of thought has a number of very prominent adherents, notably Robert Gordon, Larry Summers and Paul Krugman, to name a few contributors to a recent report on the topic. They argue that a combination of demographics, indebtedness and low overall productivity from technology mean that the long-term growth rate in the US and much of the developed world will be low for some time.

It is tempting to regard this view as the behavioural residue of the financial crisis. Having been biased to overconfidently consider that “this time was different” before the crisis, forecasters and economists are now conditioned to be more miserly in their prognostics. But if they are correct, our globalised economy must necessarily suffer the same low level of growth as the rest of the world. Worse still, without a decisive acceleration in growth elsewhere in the world, the euro zone economy may itself be moribund.

Already, with the level of economic output in Europe still below its pre-crisis level and its slow recovery is provoking comparisons with Japan’s “lost decade”. Of course, for indebted euro zone countries the prospect of low growth rate carries a silver lining in that it means that interest rates should remain low also, provided that markets do not begin to worry about the impact of low growth on the solvency of countries like Italy.

So far, in this “rebound” chapter of the epic that is the euro zone crisis the words and to an increasing degree the actions of Mario Draghi have carried the euro economy. He is the only pan-European leader on the continent, and his reputation stands high, in great contrast to those of Barroso or Van Rompuy. His four-year spell at Goldman Sachs represents the sum of financial market experience on the ECB’s governing council (Peter Praet was an economist at a Belgian bank and many would argue that this “doesn’t count”) but despite this the council has so far managed to stay ahead of market expectations. However, the ECB will very soon run to the limit of what it can do to aid the euro zone economy.

Unlike the US, where capital markets play a vital role in the funding of corporations and the real estate market, Europe is more “bankcentric”. In the aftermath of the financial crisis, perhaps a more important difference between the continents is that Europe is a conglomeration of different economic models, whose various recessions have been provoked by disparate causes which in time will require distinct remedies. As in a hospital ward where one patient suffers from a broken leg, another gout and another cancer, a common treatment will fail to cure the majority of the patients. The euro zone is a confederacy of very different recessions and it will require policy surgery to adapt the ECB’s magic potion to cure each one.

This, together with the likely prosecution of QE in Europe and the anchoring of US monetary policy to detailed developments in the labour market raise the deep-rooted question of policy appropriateness. In some quarters the debate has not yet reached the “cure”, with many still debating the origins of the crisis that have produced such a hesitant recovery. In Ireland, for example, some blame our economic collapse on German savers, others on weaselly politicians, corrupt bankers or greedy property speculators. A coherent explanation of the type of boom and bust we have suffered comes in the form of Atif Mian and Amir Sufi’s House of Debt, whose title at least, could not be more “Irish”, if I may put it that way. The contribution of the book is to clearly explain the development of what is called a balance sheet recession – the taking on of large amounts of debt by consumers and the subsequent debilitating effect that the overhang of debt has on household spending. Balance sheet recessions tend to be immune to more typical policy remedies such as government spending, and only end to come to an end once debt levels have been run down to manageable levels. In this way the argument presented by Mian and Sufi is apt for the euro zone, because it helps to explain how the presence of debt in household and business balance sheets has led to demand for bank loans across the euro zone being so sluggish.

To an extent, many Irish people would find little novel in this book in that it reflects their economic lives of the past seven years, though had it been published before the financial crisis it would most likely have been pilloried. If the book falls short, it could be in a lack of broader analysis of how monetary policy and aspects of fiscal policy can prevent and soothe the effects of “balance sheet recessions”. Similar works, such as Gary Gorton’s Misunderstanding Financial Crises, have devoted more thought to how regulation, for example, can be changed to curb financial risks.

Against the backdrop of the euro zone crisis, another contribution is to underline the message that the cure to a crisis must fit the cause. The current state of the euro zone economy is testament to this. Within the zone, Spain and Ireland are classic Mian and Sufi cases; their view is that the best remedy for balance sheet recessions is debt reduction and forgiveness, which has already been implemented to a degree in the case of Greece.

Whether they intend it or not, another contribution of the Mian and Sufi book is to view economies from an accountant’s rather than an economist’s point of view. This is good news for Ireland, where we have traditionally lacked formally trained economists in the halls of power but where many political leaders have held accounting qualifications. Charles Haughey was a trained accountant and Bertie Ahern was nearly a qualified accountant.

An accounting rather than economics view of Ireland might in fact fare better given that few economists had forecast the multiple twists and turns that the large developed world economies have taken over the course of the past seven years. Institutions have also suffered. For example, Sweden’s Riksbank has politely outed itself as “one of the forecasters whose forecasts for inflation and the repo rate in 2013 were furthest from the outcome” and has now employed the services of Sir Mervyn King to help understand why its view of the Swedish economy has so differed from reality.

Then, understanding the Irish economy has its own difficulties. It is a multi-spotted mongrel. Formally speaking it is a euro zone economy, though it is stuffed with American companies and barks like the British economy. Then there is always a significant risk that because of its size and openness, Ireland’s recovery is simply a reflection of what happens elsewhere in the global economy. From an accounting point of view, there are at least two considerations – the profit and loss account and the balance sheet.

To start with the profit and loss view, where GDP is the country’s revenue line. In the context of recent growth figures there is a risk that Ireland’s growth outlook suffers from inflated expectations. “One–off” items like a rebound in property prices or the value added by multinationals in Ireland should be stripped out of the figures we use to assess our long-term economic health. Instead more attention needs to be given to what accountants might call “operating profit” or economists refer to as trend growth levels.

For a small open economy, the trend growth rate is bounded by the health of international trade, the attractiveness of the business climate and the extent to which there is structural growth in domestic business creation. In this respect Ireland is much better off than many of its euro zone neighbours like France, but this means that it should enjoy a long-term growth rate of close to 2 per cent rather than below 1 per cent. Expectations of sustained growth in a range of 4 per cent to 8 per cent are fallacious, and in recent economic history have only been achieved in a post-crisis environment by the likes of Hong Kong and Singapore, piggybacking on Chinese growth.

Again, compared to the progress made by other euro zone countries there is much to praise in the way Irish households and businesses have endured the crisis. Having once been a “miracle” economy and model for others to follow, there is again a risk that Ireland again becomes a model for the policy of austerity. Those in Brussels, Frankfurt and London who increasingly lionise the Irish economy should have some thought for those who also bear the social costs of the crisis and for the fact that we have not yet apparently learned its lessons. Two examples underline this. One is the way in which the mania for house purchase has returned, to the great detriment of social housing and households who rent. In this respect, the housing market continues to be Ireland’s Dutch disease in that there is a persistent belief that property speculation is a means of generating wealth and a productive form of economic activity in its own right. The other lesson that is avoided is the need to create an institutional mechanism whereby domestic fiscal policy can be appropriately matched to the level of interest rates set by the ECB. Until this is done in Ireland and the other small countries in the euro zone, the euro will continue to flip the dial on their economies from “too hot” to “too cold”.

To move to the balance sheet view, the central theme in Mian and Sufi’s book is that in order for a debt-laden economy to recover and move forward, it must first resolve its past. The remedies the book suggests to deal with the overhang of debt will also touch a chord with an Irish audience because they centre on debt forgiveness.

There are several options open here. The first, which we might term hair of the dog, touches on the recent approach of replacing IMF debt with new lower-rate debt. This is wise, though at the same time limited in terms of its overall impact on the state’s indebtedness. A related and more provocative solution, which might be particularly attractive if the Department of Finance’s forecasts of medium-term growth are to be believed, is to issue more debt to fund labour-intensive projects such as the build-out of infrastructure. However, the only solution to an economy mired in a “house of debt”-style recession is to break the vicious circle that prevents household debt been written off to bank balance sheets and thus in turn to the state balance sheet. This process, if it is ever contemplated, will need to follow the following steps.

Household debt and some small business debt will need to be restructured by banks, potentially in return for equity in the properties and even in the banks themselves. The banks will in turn need to be refinanced, by markets and potentially the state. The banks themselves continue to require an operational overhaul. The state itself will then need a restructuring, most likely through a very long extension of the maturity of its debt. This sounds very simple, in way like a “free lunch” at Wall Street’s most expensive restaurant. The question is what kind of conditions could bring it about. A successful realignment of our debt would require the background noise of another surge in European interest rates and/or a deep euro zone recession, a carefully thought out plan for a restructuring and a highly imaginative quid pro quo from the state (this should come in the form of domestic institutional and policy reform rather than a ceding of more powers to Brussels).

Quantitative easing by the ECB will not have the same impact on our economy that debt restructuring might. In the event of QE, bond yields may rise should markets believe that it will be successful in increasing growth and inflation expectations. This is what has happened upon the beginning of the three waves of QE in the US. Higher interest rates will limit growth of indebted economies. An ultimately better plan might be for the ECB to act as the coordinator and financial facilitator of debt restructuring in high-debt euro zone economies.

Despite the rebound in our economy, the high level of government and household debt will act as a brake on our economy and will probably be the overriding determinant of the long-term level of growth Ireland can enjoy. Some years ago, in the immediate aftermath of the global financial crisis there begun a debate as to what shape the economic recovery in the US would take. In what became known as the “LUV” economy, commentators discussed whether the path of the recovery would be lethargically L-shaped, a more traditional U shape or whether it would follow a sharper V-shaped rebound in activity. Since then, the US has seen all three varieties of recovery, in addition to a W-shaped double dip in 2012. In Ireland’s case, in the absence of a daring operation to cut the debt burden on the state and household balance sheets, our economic future may be L- rather than V-shaped.

Michael O’Sullivan is the author of Ireland and the Global Question, published by Cork University Press.

 

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