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.

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.

Time to accept some responsibility

Many people are of the opinion that the economic problems that we are experiencing in Ireland were not of their making them. No, the general sentiment is that the huge party which we have experienced during the past 10 years was destroyed by a couple of gate crashers known as the "american sub primers" and we are nothing more than innocent victims.

This is a cop out and just simply abdicates us of any responsibility. It was always going to end in misery because we were living on credit and even if the sub prime problems had not developed we would have to pay alll the money back someday.

The economy in Ireland never had a truly sound foundation because so much of our economic resources were focused on us simply trading goods and services between ourselves. Such activity does not bring money from foreign shores which is then reinvested in the economy to produce more goods or high quality public services.

Short Termism-Government

The symptoms of an economic bubble include prices deviating strongly from intrinsic values and market players acting irrationally. Example of such behaviour in Ireland include Sean Dunne spending €54 million per acre for a hotel in Dublin 4 to middle class famillies owning three or four investment properties.

Though there is plenty of evidence from economic history such as Japan(1990-2003) and Tulip mania(1630's), to suggest that "the bigger the boom the bust" this government did nothing to prevent or limit the size of this bubble.

Why? Any action by the government to limit the size of the bubble would damage its survival because its fate was inextricably linked with that of the construction sector. Evidence to suggest this includes;

• in 2004 the construction sector represented 12% of GDP, there were 262,700 people employeed in the sector (as opposed to 165,200 in 2002),
• One eighth of workforce employed in construction; 1 in 5 of private sector workforce depending on construction ,
• And finally a Davy Stockbrokers report says tax revenue from the property market - including VAT, stamp duty and capital gains tax - has tripled since 2002 and will account for almost 17% of tax receipts this year. This report finished by stating "the public finances are now exposed to a downturn in the property market."

Therefore, they did nothing because they were only concerned with the short term; winning the next news cycle, the next opinion poll or the next election.

Ireland's Reckless Banks

Irish banks have placed themselves into a very difficult position. They have lended so much money to Irish property developers that they will find it difficult to remain solvent if the continued downward trends in the property market continues.

In a note, by Morgan Kelly of UCD, he notes that lending to builders and
developers continues to grow rapidly and now stands at almost €100 billion, an increase of
€20 billion on last October. To put these numbers in perspective, €20 billion is twice the market value of Bank of Ireland shares; while €100 billion is the approximate value of all public deposits with retail banks. Effectively, the Irish banking system has taken all its shareholders' equity, with a substantial chunk of its depositors' cash on top, and handed it over to builders and property speculators.

He adds international experience shows that developers will walk when markets turn down, leaving banks, and often governments, to pick up the pieces.

Therefore, all this money has been thrown recklessly into the irish economy by Irish banks. Creating positions which were completely unsustainable, once the tap was closed off. Thus, the returns for developers will be significantly reduced and perhaps in some cases result in developers holding loans greater than the returns possible in the current market conditions.

There will have to be major movement in the coming months in the economy for us to reach a position where the equilibrium is based on real market fundamentals and not on speculators greed.