The Economic Charade of the Irish Bailout

Can Ireland export its way back to solvency? That is the question underlying Ireland’s ostensible recovery budget. The Irish tale is a familiar one: boom, bust, and bailout. Of course, in an era marked by spectacular recklessness, Irish banks distinguished themselves -- perhaps only matched by their government; an ill-considered guarantee of financial sector liabilities in 2008 turned banking insolvency into sovereign insolvency. Austerity followed. Mounting losses -- and some imprudent remarks from Ms. Merkel -- drove up borrowing costs, eventually forcing the joint EU/IMF rescue package, and further austerity. Unfortunately, however, the credibility of the subsequent recovery plan is itself questionable.

Sectoral surpluses and deficits must balance. Consequently, any fiscal consolidation must be accompanied by some combination of a stronger trade position or increased private spending – or the economy will shrink. The Irish budget recognizes this reality, although it is a bit reminiscent of a student working backwards from the correct answer.

Starting from the targeted 2.8 percent of G.D.P. public deficit in 2014, the Irish government strains to make the pieces of the economic puzzle fit. An aggressive export forecast – as much as is credible -- is the second component of the budget. It leaves an implied private sector surplus of roughly 5.5 percent of G.D.P. – improbable, but not implausible. Alas, this misrepresents the economic pressures besieging the Irish government.

The 2.8 percent of G.D.P. government deficit is not in fact a 2.8 percent deficit. Ballooning interest payments (mostly abroad) turn a projected deficit into a primary surplus. Moreover, the balance of trade is not a reliable proxy – which the Irish government assumes is the case -- for the current account for a small, open economy; repatriated export profits from foreign multinationals reduce the headline trade number. Together, these facts conspire to understate the necessary adjustments from the export and private sectors by some 3-4 percent of G.D.P.

Can it be done? With loans outstanding to households still near 111 percent of G.D.P., the burden of this greater adjustment will almost certainly fall on net exports rather than private spending. Monetary union means only “internal devaluation” – deflation – remains as a mechanism to regain competitiveness. Already, Irish unit labor costs have begun to fall after soaring much of the last decade. There is a limit, however, to how far wages can come down in a heavily indebted society; otherwise, Fisher’s debt deflation beckons. Ireland’s best chance is for the labor costs of its main trade partners to adjust upward instead. That is a faint hope in a world beset by nascent trade war.

Critics argue the rescue package amounts to little more than a backdoor bailout of German banks by Irish taxpayers. The truth is even more scandalous. Indeed, Germany has made a profit of several hundred basis points from the bailout. This charade cannot continue. Debts must be restructured to payable levels. Delay only increases the collateral damage to the Irish people – and to the Eurozone’s viability.

The Road to Revolution in Beijing Runs Through Riyadh

Egypt is not Tunisia. Bahrain is not Eygpt. Saudi Arabia is not Bahrain. Such has been the tragicomic refrain from besieged capitals across the Arab world, as protests have put a lie to the illusion of stability that had seemingly prevailed (the same, of course, applies to the PIIGS and the Euro sovereign debt/banking crisis). These hollow protestations certainly belie the reality in the streets, but there is at least a hint of truth here: these are economically disparate societies. Yet none have been spared from unrest; not the rich (Oman and Bahrain), nor the poor (Yemen and Mauritania) nor the middle class (Tunisia and Egypt). Rather, the propaganda of the deed, swarms of unemployed youths, and -- yes -- food inflation have conspired to kindle revolutionary fervor across rich and poor country alike throughout the Arab world. But now the question becomes, will unrest spread beyond the Middle East or will this solely be remembered as the Arab 1989 (or 1848, depending on one's historical perspective)?

Which brings us to China. For the past twenty years, there's been something of a Western cottage industry endlessly predicting the imminent doom of the Chinese regime. And for twenty years, the reports of the CCP's demise have been greatly exaggerated. But at risk of succumbing to the same folly, this time really might be different. Indeed, the Chinese economy seems near a de Tocquevillian moment: doing (very) well, but not well enough. Thirty years of staggering growth have lifted untold millions out of poverty, but, as you would imagine, have also dramatically increased future expectations. And now there are legitimate concerns about a coming economic slowdown -- which Chinese authorities are keenly aware could prove fatal to their rule. 

 The Chinese government aggressively responded to the loss of export demand due to the financial crisis with a stimulus package that dwarfed any seen in the West, on a GDP-adjusted basis. This credit-driven growth, however, seems to have mainly contributed to an unsustainable property bubble. Ghost towns, empty office buildings, and off-balance sheet local government debt - it's all enough to make contrarian hedge funders perk up. To its credit, the Chinese government has tried both to gently deflate the bubble with higher reserve requirements and interest rate hikes, and to ameliorate the squeeze ordinary Chinese are feeling with an increased commitment to building affordable housing -- although none of these measures have yet been much effective.

Of course, the Chinese government is nothing if not vigilant when it comes to threats to its "harmonious" society. With soaring food inflation fueling simmering discontent over endemic corruption and abuses of power, the state was quick to shut down the copycat "Jasmine Revolution" Chinese web activists tried to organize several weeks ago. For Westerners quick to pounce on any evidence of discord in the Middle Kingdom -- including US ambassador Jon Huntsman, who conspicuously showed up at the pre-arranged protest site in Beijing -- the abortive demonstrations were certainly disappointing. The, perhaps unsatisfying, reality seems to be that there simply isn't widespread support for Tunisia-style protests in China. After a century of nearly unfathomable hardship, the Chinese people are loathe to force out a regime that, while undeniably corrupt, has delivered near miraculous growth and improvements in living standards. Put simply: despite indignation about abuses of authority, few are willing to risk killing the golden goose.

But that calculus changes with $200-a-barrel oil. The perturbations in the oil market due to the nascent civil war in Libya disrupting its supply reveals just how little spare capacity exists today. Libya only accounts for approximately two per cent of global production, but even asking the Saudis to dip into their (questioned) spare capacity to meet that shortfall stretches the market thin. Of course, Libya (and possibly Algeria) are only a sideshow to what a full-fledged revolution in Saudi Arabia would mean for oil prices. While it's certainly unclear whether protests will materialize in either Riyadh or Jeddah on the Saudis' scheduled "Day of Rage", it seems much more likely that its Eastern province will erupt. Like neighboring Bahrain, which itself has been gripped by demonstrations, Saudi Arabia's Eastern Province is home to an aggrieved, restive Shia majority -- and just so happens to be where its largest oil fields are located. Indeed, Saudi security forces have already clashed with protesters in the eastern city of Qatif, firing on them with rubber bullets a day ahead of the "Day of Rage". Prolonged unrest in the Eastern Province clearly has the potential to send oil prices parabolic, which in turn would torpedo the global economy.

The Chinese government would hardly be alone in being vulnerable to an unexpectedly bad economy due to an oil shock. The not-so-dirty secret of the Great Recession is that everywhere it has left in its wake the social preconditions for revolution: un-and-underemployed young men (in China, these are the so-called "ant tribe"). Regimes from Azerbaijan to Vietnam could very well be on the proverbial chopping block. Oil would be the revolutionary transmission mechanism, giving an economic push to already combustible milieux across the globe. The usual caveat that protests certainly do not guarantee a revolution is worth remembering; the shadow of Tiananmen and the simple truth that all revolutions come down to whether the army will fire on protesters casts a pall over any such discussion. Still, don't be surprised if a new line comes out of Beijing during the coming months: China is not Saudi Arabia.

Uh Oh: Kevin Hassett Likes Obama's Business Tax Credit Proposal

How do I know Obama's proposed business investment tax credit won't do much to stimulate the economy? Kevin "DOW 36,000" Hassett thinks it's a great idea.

Indeed, Hassett makes quite the case for this latest round of giveaways to Corporate America growth-oriented tax policy:

Because the benefit of expensing depends on the time value of money and interest rates are currently quite low, one might think that expensing would have a small effect now. Nevertheless, all but the most prominent firms have to pay interest rates that are much higher than Treasury rates today when they borrow.

Actually, Hassett had it right the first time. This latest measure won't do much. Just ask incoming CEA chair Austan Goolsbee, whose academic work included looking at such tax credits:

Econometric research has commonly found that tax policy and the cost of capital have little effect on real investment. [...] For policy makers interested in using tax policy to stimulate investment or, especially, to smooth business cycle fluctuations, the results are not promising.

Which makes you wonder, who exactly is telling Obama this is good economic policy? Or (more likely) is this just a ploy to appear less "anti-business" with midterm season in full swing?

Quantitative Easing Or Helicopter Drop? What Should Ben Bernanke Do?

A lonely nation turns its eyes to you, Ben Bernanke.

Double dip fears run rampant (despite a better than expected August ISM number). Fiscal stimulus is waning -- much of it undone by draconian cuts at the state and local level. Housing looks poised to go cliff-diving again now that the homebuyer's tax-credit has expired. And, of course, unemployment remains stubbornly high.

The high priests of economic orthodoxy assure us if we just embrace fiscal austerity or higher interest rates that we can ward off the dangers of debt deflation. Which is to say, they are incoherently grasping at any justification to foist contractionary policies onto a weak economy, all in order to fight the specter of incipient -- only in their minds -- inflation.

But with short-term rates up against the zero bound, what ammo does the Fed have left to support the fragile recovery? Here are the usual suspects of unconventional policy tools:

1) Resume quantitative easing. It's debatable how much banks substituting one non-interest bearing asset for another helps the real economy. Additional cash seems likely to either pile up as excess reserves, filter into the markets or get arbitraged via more Treasuries. Still, it's better than nothing.
2) Credibly commit to a higher inflation target in the medium-term. Targeting a 4% inflation rate over a prolonged period obviously not only makes holding cash less appealing, but also reduces real debt burdens. Of course, Messrs. Fisher and Hoenig would do everything in their power to undermine such a project to return to 1980s-level inflation.
3) Buy longer-dated Treasuries. Pushing down yields on longer-dated Treasuries makes other, riskier assets more attractive. Even just credibly threatening to buy up longer-dated Treasuries could be enough, if yields aren't already too low.
4) Eliminate IOER. The Fed currently pays out 0.25% on excess reserves, but why not cut that down to zero? Or even impose a penalty rate? Banks would pile into other short-term assets and increase their vault cash, but at least some of that otherwise idle money would leak into new loans (although there could be some unintended consequences vis-á-vis money market accounts).

Those are just the more conventional "unorthodox" measures the Fed could pursue. Another option would be quantitative easing to non-banks, i.e. direct lending. This is where monetary and fiscal policy meet. The key is that it would entirely eliminate the excess reserves problem, though it would introduce the question of favoritism -- an issue the Fed would be loathe to raise given the recent assault on Fed secrecy.

Still, the radical idea of the Fed giving money to businesses and households rather than to banks liable to sit on it holds some appeal. The so-called helicopter drop would accelerate the deleveraging process, effectively papering over bad household debt. Indeed, from what we know about lump sum tax rebates, we would expect households to save/pay down debts with their one-time check from the Fed. So a good portion of this newly minted money would still end up at the banks, just as with quantitative easing, though it would come at the cost of reducing the banks' claims on households.

But wouldn't this debauch the currency? If the Fed gave away free money, essentially accepting anything as collateral, they wouldn't have the assets to sop up the excess liquidity and prevent out-of-control inflation on the other side. This is the issue some have raised with the Fed accepting MBS as collateral: the Fed is holding MBS at inflated values, so when it comes time to sell that paper, the Fed won't take out as much money as it put into the system -- hence, inflation.

This is where the Treasury comes in. As MIT professor Ricardo Caballero points out, the Treasury could simply transfer T-Bills to the Fed to sell, basically the reverse of monetizing the debt. The Fed would never countenance such extreme action but it's worth remembering that Ben Bernanke circa 2002 was correct: a determined Fed should be able to reverse deflation. Too bad he's not running things nowadays.

Welcome To Tim Geithner's Recovery

In economics, as in war, simply declaring "Mission Accomplished" does not make it so. Reality is stubborn. But that didn't prevent Tim Geithner from taking to the New York Times to celebrate our "recovery" in a transparent effort to gin up increased confidence.

In effect, Geithner saluted policy-makers for avoiding a replay of the 1930s, settling instead for a prolonged period of stagnation, á la Japan's Lost Decade; what PIMCO dubs the "new normal". What a salutary result! Implicit was a rebuke of those worrying about the possibility of a double-dip: after all, the economy grew at a rate of 2.4% 1.7% in the second quarter of 2010. Modest but still tangible growth, no?

Of course not. The economy is clearing slowing. The inventory bounce is fading. Fiscal stimulus is waning. Republican obstructionism eliminates any hope of further spending. Cuts at the state and local levels will actually bring about fiscal contraction over the coming months. The Fed frets that further action could spike inflation. At best, Bernanke & Co. won't withdraw the little monetary stimulus they have provided, at least in the short term. In short, the second derivative is slumping. It's conceivable that the first derivative could reverse itself over the next few quarters. But even that is largely irrelevant. Whether the economy grows at a rate of minus or positive one-percent, there still will not be enough growth to add enough jobs to alleviate our now persistently high unemployment. We have simply arrested the freefall and called it a recovery.

And there are still, of course, rather massive tail risks to our fragile "recovery". Housing in the U.S. is on a downward trend again. Europe's banking/sovereign debt problems (they are one and the same) still hover like a specter over the continent. And China's housing bubble could pop to devastating effect.

Welcome to the recovery, indeed.

Paul Krugman, Iceland And The Council Of Foreign Relations: A Study In Conventional Incoherence

If there's one thing Serious People despise, it's being questioned. Never mind that the establishment has listed from one catastrophe to the next over the last decade; alternatively cheerleading the Iraq quagmire, financial deregulation, and -- now -- austerity. No matter the outcome, Serious People are always right; power absolves them of responsibility for the consequences of their actions.

So it shouldn't be too surprising that the "centrist" Council on Foreign Relations -- that venerable body that sees fit to employ know-nothing Amity Shlaes as an economic "specialist" -- has declared war on Paul Krugman. After all, as the leading Keynsian economist, Krugman has incisively and incessantly challenged the emerging conventional wisdom that budget deficits need to be immediately restrained and monetary officials should to be wary of incipient inflation. But even by their normally economically illiterate standards, their last attack is particularly baffling.

In their latest broadside, the CFR takes issue with Krugman's post on Iceland, which would have seemed relatively unobjectionable. Krugman merely pointed out that since Iceland controls its own currency, and can thus devalue it, they had fared much better during the financial crisis than other small, open economies. Indeed, the three countries Krugman compares Iceland to -- Ireland, Latvia and Estonia -- have been forced to maintain overvalued exchange rates, either because they're already a part of the Euro (Ireland), or have their currencies pegged to the Euro in hopes of joining (the recently admitted Estonia and Latvia), which has led them off an economic cliff. Unemployment has soared to Great Depression levels in the pair of Baltic states. Trimming their budget deficits and keeping their currency pegs in the face of the slump has starved their economies of any demand. Meanwhile, Ireland has suffered its own collapse and slide into deflation, thanks to the effective Gold Standard that is the Euro. That a quick devaluation is preferable to years of grinding deflation would seem obvious, yet it escapes the CFR.

Here, it's worth remembering too just how spectacular Iceland's bust was in 2008. Iceland's bankers quite literally bankrupted the country. After erecting their own mini-financial empires built on piles and piles of debt, Iceland's financiers left the country with a bill larger than its GDP when it all inevitably went bad. It's no exaggeration to say that Iceland suffered one of the worst financial collapses in history. And yet, just under two years later, Iceland is doing better than the aforementioned trio of Ireland, Latvia and Estonia, who have adhered to the economic orthodoxy of deflation and austerity with stunning zealousness. If ever there was proof that the large monetary shock of devaluation, which instantaneously makes exports more competitive, is an effective way to jump-start recovery out of severe recession, this would seem to be it.

But not so, says the CFR. See, if you just look at Iceland's performance compared to the others from a few months before the panic in 2008...you see that Iceland only slightly outperforms the others, rather than clearly outpacing them. And if you go all the way back to 2000, Iceland has gained less in terms of GDP growth than the others! And if you go back to 1950....

Not only is this analysis misleading -- the question is how these countries have performed since the acute phase of the crisis hit -- but it entirely misses the point. By all rights, Iceland should be far, far behind the others; their banks owed more than their government could pay. As dire as the situations in Ireland, Latvia and Estonia were, they weren't quite that bad. But obstinate policy-makers have crucified their economies on a cross of Euros, which has condemned them to zero or negative growth and spiking unemployment. Meanwhile, Iceland has bounced back towards the beginnings of a recovery; something inconceivable two years ago. Of course, devaluation is not a panacea, but it's the best bad option in this context. This is rather elementary stuff.

It's as if the CFR is bellowing at Krugman for presuming to question the great Oz, not realizing that the curtain has been drawn on their intellectual bankruptcy. Eventually, the truth always wins out.