Boston V Berlin:Part 1

In a recent blog entry, Paul Krugman wrote that perhaps"the productivity gap between America and Europe never happened" as much of the apparent US productivity miracle may have been nothing more than a statistical illusion created by the USA's bloated finance industry.

He writes this based on a recent report by Dean Baker and David Rosnick. In the paper they calculate the “usable productivity”, the productivity that can actually be used to raise living standards. They contend that the "usable productivity" offers a more accurate assessment of economic well being than simply relying on productivity data because it can be directly translated into improvements in living standards

When the "productivity performance" of the United States is compared to those of other OCED countries it is substantially worse than what the conventional data indicates in both the period 1980-1995 and in the period 1995-2005.

The consequences of this data for Irish and European economic and social policymakers are momentous as for the last 10 years, Politicians throughout Europe have looked at America's wealth and opulence with great envy.

Thus, many European politicians have adopted the American neo-liberal ideology in the hope of creating the same for their citizens wealth. For example Tony Blair, Gordon Brown , Sarkozy and Schroder were all elected on the back of neo-liberal market reforms and low taxation.

While specifically, in relation to Ireland Mary Harney declared in 2000, that "Geographically we are closer to Berlin than Boston. Spiritually we are probably a lot closer to Boston than Berlin."


Why property is still overvalued!!!!!!!!!!!!!!!

But additionally, this graph show details why the Irish financial sector is in so much trouble. When property prices return to the long term mean, the level of write offs required by the banks will be massive. These write offs will drown the financial institutions themselves and perhaps even the exchequer.


The Bank Bailout

The bailout of the banks through the establishment of the National Asset Management Agency is not only inequitable but completely disgusting. The citizens of Ireland will be paying for the reckless lending of the banks to not only the property developers but low income mortgage holders for at least the next 10 years.

Nonetheless, the bailout is necessary. Without a mechanism in which credit can be pushed out into the economy in order to establish new businesses or for the private sector to purchase assets of any class, recovery will be impossible.

Yet, the removal of these so called "toxic" or "legacy" asset should not be seen as the end of our economic crisis. Previous history of massive property bubbles has shown that even if credit is made available to the private sector once more. Companies and individuals will be unwilling to borrow, as will prefer to pay back their existing debt. Thus, it is important that the Department of Finance do not place all their energies into the creation of NAMA as this is only a small part of the solution.

New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”

The scheme as presently presented will result in the complete nationalization of the Bank of Ireland and AIB in the short to medium term. A recent research by CLSA highlighted that banks throughout the world have only began the process of write downs.As on average banks have only marked down assets to 98 cents on the dollar. Yet, previous history, from Japan for example suggests that the valuation of assets peak to trough could be as much as 87%.

Therefore, if the government are not going to overpay the banks for these toxic assets the write downs will be so significant that new capital will be required. The Government will provide this capital through ordinary shares.


Pass the parcel

On Tuesday, Brain Lenihan, the finance minister will announce plans to increase taxation and reduce expenditure. This will reduce the governments borrowing requirements and make it somewhat cheaper for the government to source more money in the future.

Therefore, the balance sheet of the government will improve. Yet, this is no reason to celebrate. As the improvement in the balance sheet will be caused by transferring risk from government to the private sector's balance sheet.

Thus, there will be further increases in unemployment, businesses will close but more saliently many more people will begin to default on their mortgages.

The level of default on loans will overwhelm so many of the Irish banks that the Irish government will be forced to take not only the risk but now the actual loans on their balance sheet.

As a consequence, Brain Lenihan will be faced once more with the exact same issues he was hoping to address as Government borrowing will becomes more expensive and our borrowing requirements will increase again.


Where is the Irish Economy going? Off a cliff

Last week, it was reported that the Irish economy experienced a 7.5 % contraction in GDP in the last quarter of 2008. The situation has more than likely deteriorated further in the first quarter of 2009.

Government tax receipts have experienced a similar contraction, with the government now expected to only collect €34 billion, a shortfall of €24 billion against the November Budget forecasts.

In response, the government will hold a "mini Budget" on April 6th. This Budget aims to reduce this shortfall by increasing the government's taxation take. Such steps should reduce the level and the cost of Irish government borrowing.

However, by sucking money out of the economy the government will hasten the deterioration of the economy as demand for goods and services will only reduce further, causing businesses to close and create even more unemployment. As a consequence, the economy will become deflationary.

Deflation is a very dangerous economic condition in any country, but especially when her citizens are not only crushed and cumbered with debt but are in severe negative equity on the assets which they borrowed for.

In the early 90's, Japan's economy experienced these very symptoms. Japanese consumers had borrowed and borrowed during the late 80's causing massive increases of commercial and residential property valuations. For example, real estate in Tokyo sold for as much as $139,000 a square foot—more than 350 times as much as property in Manhattan.

When, the bubble burst the value of these properties fell by as much as 87%. In response, Japanese consumers stopped borrowing money from banks. Investing in new businesses or buying new electrical goods fell dramatically. Instead, consumers just paid back debt. The Japanese paid back debt until their liabilities equaled their assets. This process lasted about 10 years.

According to Richard Koo of Nomura, the Japanese experienced "the largest loss of wealth in human history during peace time." Yet, the highest rate of unemployment during this "lost decade" was only 5.5%. This was achieved by the government filling the gap created by the absence of the private sector by borrowing the money that the private was unwilling to borrow.

Yet, in Ireland we are going to the exact opposite. The government will not borrow more money, but instead will introduce a monetary contraction policy, despite the lessons of Japanese.

This is suicide, as the only result will be further reductions of GDP and more and more unemployment.


Monetary Expansion & Monetary Contraction

In the aftermath of the great depression, Mr Hoover wrote a letter to the president elect, Franklin D Roosevelt. In the letter Hoover informed Roosevelt that "it would steady the country greatly if there could be prompt assurance that there will be no tampering or inflation of the currency; that the budget will be unquestionably balanced even if further taxation is necessary; that the government credit will be maintained by refusal to exhaust it in issue of securities"

This policy of Hoover was essentially a rejection of the tools of fiscal and monetary policy that were at his disposal. These tools could of limited and reduced the effects of the Wall Street Crash. As a consequence America sled into a very significant deflationary spiral between 1930-1933.

Ben Bernake, the present chairman of the federal reserve has studied the Great Depression with great depth. One of the main conclusions of his studies, is that this deflationary spiral could of been avoided if the Federal Reserve had not caused a contraction of the money supply. Such a contraction is known as monetary contraction

However, there are some very real dangers of implementing a policy of monetary expansion, the opposite of monetary contraction.

If monetary expansion is two aggressive, this will result in significant inflation. Very strong inflation will destroy people's saving and pension funds, place upward pressure on prices and result in social upheaval. Yet, very strong will inflation would have the positive effect of eroding the real value of debt and liberating the borrower from his repayments. Though such inflation could be seen as a reward for reckless borrowing and raises some questions in relation to moral hazard.

Therefore, a policy of expansionary expansion is as dangerous as a policy of monetary contraction as it can destabilize an economy even further, damage consumer sentiment delay any upturn. Thus, an equilibrium must be found between each policy.