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.

Short Termism--Banks

Shares in all Irish finanicial institutions have seen huge falls in recent months. However, this week has seen new lows with shares in Bank of Ireland and Anglo Irish Bank falling below the one euro for the first time. These new lows were on the back of some horrendous news from Bank of Ireland in relation to an increase in its bad debt provision and the introduction of a no dividend policy for the forseable future.

Bank Of Ireland and all other banks in Ireland are commercial banks. They work by providing loans to companies and individuals. They fund these loans through their customers savings. Normally, banks only lend money in relation to the extent of their deposit base. This is prudent lending and allows the banks to pay their liabilities as they fall due.

However, in recent years the banks began to source money from outside their deposit base through wholesale funding, because technology and innovation was meant to have allowed them to control and assess risk to a much greater degree than was possible in the past.

But once, the banks realized that they could not manage this greater risk they fell into severe trouble because access to these new credit sources closed. This created new reduced credit conditions and led to a reevaluation of all asset classes and the beginning of this write down cycle. This write down cycle has thus reduced the ability of banks to meet their liabilities as they fall due.

However, how did the banks get themselves into these positions.

SHORT TERMISM.

The banks were only concerned with ensuring that each years annual profits were greater than last, that their market shares grew and that the share price increased each day instead of ensuring the protection of an ancient and venerable institution established by a Royal Charter in 1783.

While those those working in the banks were only interested in ensuring that their bonus cheques were as large as possible. And who can blame them, when we live in a world where there is little job security and companies offer employees nothing more than "yellow pack" pensions.

Why Is This Downturn Occurring?

The world economy is now entering a severe and prolonged recession. The cause of this recession lies with the financial and banking sector.

Our banking systems works through a mechanism known as fractional banking. In this system, customers give their money to the banks in the form of savings, while the banks lend this money to customers to set up companies or to buy cars. This lending fuels the economy and improves economic well being. However, fractional banking requires banks to ensure that the ratio between their lending and deposits are at a level that allows them to have sufficient cash to cover their liabilities as they fall due. 

However in recent years banks lending was not based on the amount of customer savings they had, but instead on external sources. As a result, banks were now abandoning these ratios and overextending themselves. In the process they were pumping huge amounts of additional capital in the economy

This additional capital led to a significant increases in asset prices. Capital thus chased these higher returns and this money then trickled down and created a significant sense of well being among the population.

Thus, a huge correction is now required as we pay back this debt and reach a new level of equilibrium, where the economy learns to functions without these external capital inflows.

Recession

Today, AIB had a very important earning call. In it they announed that there earning per share would be 1.20 as opposed to between 185-190 cents as they said in July. Additionally, they said they would incur bad debts of about 750 million and did not see any meaningful recovery in the mortgage market until 2011.

This above announcement highlights how unaware the establishment in Ireland were to economic downturn. They were living in an economic land where bust did does not occur and the old adage of "There is no such thing a free lunch" does not exist

The sudden nature of this downturn, with much of the media in Ireland declaring that the our fundamentals are still sound as late as June, suggests that the recession will be prolonged, sustained and severe.

Change

I really want this blog to work, but every blog I have tried so far has failed. Therefore, I am going to try and correct the reasons behind these failures and try something new.

The reason behind the failure of my attempts at blogs is the very long articles that I write that require a lot of editing to be published.

Therefore, the writing style from now on will be disciplined  and concise. This style involves

• All posts must being equal to or less than 100 words.
• Moreover there must be five posts per week. 
  

The blog will continue examining and exploring the same themes and ideas as suggested in previous posts.

George Soros on market equilibrium

Presently, George Soros is on a book tour promoting his new book.George Soros,  In the book he questions neo-classical economics where markets reach a state of equilibrium where buyers and sellers are content.

His main argument is that the neoclassical economics that postulates that markets tend to equilibrium is nonsense. He founds this view on what he calls the theory of reflexivity, which broadly says that use of scientific methodology in economics is wholly inappropriate, because economic agents cannot avoid influencing the outcomes they forecast.

If markets do not find equilibrium and thus are as likely to overshoot on the way up as they are on the way down, then should governments interfere to avoid the euphoria on the way up (i.e. during the dot com boom the peak, at March 2000 the Nasdaq was 5,132.52 ) and the despair on the way down (i.e. dot com boom collapse, in which by October 2002 the NASDAQ lost 78% of its March 2000 valuation)

However, by interfering in this way governments will limit and reduce the possibility of economic growth and thus vast improvements of standard of living and income are unlikely.

Instead,we would perhaps become a France or Germany, every year we  would just limp along with 1% economic growth. 

Would citizens be happy with this?

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.