Little by little, Ireland is edging in the right direction. Accounting windfalls aside, as a recent Goldman Sachs piece pointed out, Ireland’s main risks are now external, not domestic. Four key positive developments have contributed to this improvement. First, Ireland’s economic data have been better than expected – real GDP is running at 7% annualised – driven by strong export growth. Second the new-ish Fine Gael/ Labour government, elected in February, is pushing through the previous government’s austerity plans (yet maintaining popularity, perhaps more remarkably). Third, the attitude of the European authorities towards Ireland has changed since the European crisis intensified in July: Ireland is now presented as a beacon of successful austerity. Fourth, and perhaps related, Ireland has received a significant reduction in the interest rate it is paying on bailout funds, reducing the interest bill on government debt by 0.7% of GDP from next year.

As an Irishman living in London, I have good reason to be interested in the economic path of both Ireland and the UK. While Ireland as a small open country on the geographical edge of Europe has chosen to tie its economic future to the European mast, the UK has played a cautious wait and see policy, choosing to stay out of the Euro and to retain control over its monetary policy. As Greece teeters on the brink of collapse and speculation about the too-big-to-fail futures of Italy and Spain mounts, policy-makers in the UK are becoming prouder of their Euro-scepticism by the day.

In the short run, this rhetoric is understandable. Control over the levers of monetary policy has allowed the UK to maintain record low interest rates, to pursue quantitative easing and yet represent a relative (all things are relative) safe haven in global bond markets, keeping the UK’s borrowing costs to a minimum. The UK is currently able to borrow for 10 years at an average interest rate that is little more than 2%, while Italy has breached the critical 7% level in recent days.

Perhaps, however, in the long-run such levers create a false sense of security. While there is much talk of austerity and “biting” cuts, the reality is that between 2000-2010 had government annual expenditure stayed pace with inflation the budget would have risen from £343bn to around £450bn. That sober paced development might have seemed reasonable, yet Alistair Darling spent £669bn in 2009-10 and George Osborne will have spent £692bn in 2010-11. The notion of cuts is, in reality, closer to scratches than genuine flesh wounds. The bond markets appreciate the sense of austerity, but it is more conceptual than real.

Instead of being forced to truly address the key aspects of an inflated public sector, a decreasing level of international competitiveness, and an over-reliance on financial services, the government has been able to hide behind tools like low interest rates, quantitative easing and inflation which hurts savers but reduces the real value of the government debt. While news of economic hardship has been standard issue for the 24/7 media, the vast majority of people are not feeling much worse off than they did before the financial crisis started. Anyone with a floating rate mortgage certainly isn’t, with monthly payments at all time lows.

Jin Liqun, the head of China’s $400bn sovereign wealth fund recently accused Europe of “indolence” and “sloth”. Specifically he said: “If you look at the troubles which happened in European countries, this is purely because of accumulated troubles of the worn out welfare society.” That is a very generic analysis of Europe as a whole, and clearly each country is different. What is clear, however, is that as the massive populations of India and China develop, and their middle-classes grow, so too will their quest for knowledge and their skills base. If the world economy remains as globalized as it is currently, workers in high-cost, high-margin countries like Ireland or the UK will be under increasing pressure to prove their worth.

Failure to compete in this skills race will lead to further outsourcing, either to human capital elsewhere in the world or to investment in I.T. which doesn’t have a pension plan or healthcare costs associated with it. Recently the CIO of US asset manager Blackrock, Rick Rieder, said that he had calculated the number of productive hours that have been saved by software implementation nationwide over the past decade. It added up to the equivalent of 44 million jobs. “We have 148 million jobs in the country. Take 44 million jobs away from 148 million jobs and you can’t fix that. I think it’s a really big deal.”

Perhaps we will see a new period of Luddism in places like the US or UK, as would-be workers start smashing the production lines of Apple Computer. More likely is that labour is either going to have to become more flexible (accepting less or moving), or more skilled. Clearly something has to give.

Ireland, while not perfect by any means, has historically had a highly flexible workforce. It also now has developed a strong skills base, which goes some way to allowing it to compete on a global scale in specific industries. Almost 1,000 companies – including the likes of Google, eBay, Intel and Facebook have chosen Ireland as the hub of their European networks. Eight of the top ten global medical technology companies have a manufacturing base in Ireland. Companies investing in Ireland for the first time rose by 20% in 2010 and included the likes of Telefonica, Warner Chilcott, and LinkedIn.

Significant competiveness improvements are underpinning Ireland’s return to export-led growth – consumer prices have fallen, while competitor countries like the UK have remained on an upward path. Wages and other costs have adjusted to the change in labour market conditions, with public sector wages having been reduced by an average of nearly 15%.

Cuts in Ireland truly are biting; and will continue to bite, but the difference there is that there exists a growing sense that there is a route out of the mess. This route will be a “real” route, based around becoming more competitive in the skills race and not an “artificial” route, which sustains the self-indulgent status quo.

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The often used phrase “sovereign debt-crisis” happily lumps the PIIGS (Portugal, Ireland, Italy, Greece and Spain) into the same collective boat, but each national crisis has its own characteristics that make the likelihood of default different from country to country.

For Greece, fiscal adjustment is the key issue, as the government has been extravagantly fire-hosing the public sector with borrowed money for some time. For Portugal, however, the key problem is the private sector’s continuing external deficit: the government debt to GDP ratio isn’t that high by comparison to other Eurozone countries. The Irish situation is a banking crisis turned into a potentially unsustainable government debt crisis. Ireland can no longer raise funds on the capital markets and has had to accept a bail-out financed jointly by the IMF and the European Financial Stability Facility (EFSF), yet it has huge untapped private sector foreign assets.

Following my own national interest, the Irish situation is of most personal concern. Potential investors in Irish bonds fear that by the time the European support ends as planned in 2012, the country will still not have access to the bond markets, and might then be forced into default. In 2013 a new mechanism will replace the EFSF, called the European Stability Mechanism (ESM).

The critical difference is that under the new ESM, contributing countries bailout loans will rank senior to those of private investors, i.e. current and future bondholders. The idea is to make default possible, with only a moderate risk to the budget of the creditor nations (in other words to satisfy the German electorate). By 2013, the European banks should (fingers crossed for this bit) be in a better position than today to absorb big losses, or so one hopes.

In this context, it’s unlikely that a continuing reliance upon foreign support is going to end well for Ireland. Ireland doesn’t have access to capital markets even now, when the EFSF ranks as an equal creditor to private Irish bondholders. Unless the economic situation changes dramatically between now and the end of next year, it’s hard to believe that foreign bond investors will be jumping to hold Irish bonds, given that they will be subordinated as creditors versus the ESM, under that new regime.

This dependency of Ireland on foreign support is “difficult to understand given that the country has not lived continuously above it’s means in the past”, according to Daniel Gros of the CEPS. Ireland has run a current account deficit (i.e. the country has a shortfall between resources used and produced) for only a few years. In total, according to Gros, the current account balance over the last 25 years shows a foreign debt of only around 30bn Euros; a figure which is only 20% of Irelands annual GDP. Furthermore, Ireland is predicted to run a current account surplus for 2011, and did so in the 4th quarter of 2010.

The talk in Ireland of export led growth is correct, yet instead of the Irish private sector funding the public sector deficit it chooses to hold its assets in foreign equities, bonds and deposits. Currently 10 year Irish government bonds yield around 11% – an exorbitant and unsustainable level of interest – whereas the private sector earns very little on its foreign assets. As Daniel Gros points out, if this is allowed to go on, the “government could indeed still have to default”.

Estimates suggest that Irish pension funds and life insurance companies alone own over 100bn Euros in foreign assets, roughly €25bn of which are invested in non-Irish government debt. A recent report from the Irish public pension fund suggests that the average rate of return achieved during the past 10 years has been 1.7%.

Again picking up Daniel Gros’ point: “A very strong case can thus be made that Irish pension funds and life insurance companies should somehow be ‘induced’ to invest their entire portfolio of gilts in Irish government bonds. The Euros 25bn in financing that this would yield for the government is equivalent to the IMF contribution to the current rescue package. A massive investment in the bonds of the country, would not be just some nationalistic punt, but would be in the interest of current and future retirees, and the State as a whole.

The Irish government’s only recourse to making payment of foreign deficits is taxation. As a member of the Euro, it cannot control interest rates or devalue its liabilities by printing money, unlike the US or UK approach to ’stimulating’ their economies. Whatever interest rates the government pays on its national debt are a direct claim on tax revenues – so if rates on government debt remain high, in the absence of higher economic growth, the only alternative is to raise taxes to compensate, which will have a knock on drag on prospects for growth.

A redirection of pension fund monies would be a start in this process. Irish deposit holders should also be incentivised to ‘look to home’ as well: they are not receiving meaningful returns on deposits held in foreign banks, yet are likely to be taxed heavily in the future by a variety of means if the government cannot reduce it’s interest burden; a proverbial robbing Peter to pay Paul.

The Argentine debt crisis in the late 1990s and later default (2002) holds some lessons for the Irish situation. Argentina’s private sector, similarly, had large foreign assets while the government had an even larger amount of foreign liabilities. The country went bankrupt with only a moderate net foreign debt because wealthy Argentines took their assets to safe havens outside of the country, and thus outside of the reach of the government, while poor Argentines refused to pay the taxes needed to satisfy the claims of foreign creditors.

Ireland is different in many ways to Argentina, and perhaps most significantly there is a greater culture of tax paying than Argentina, where the wealthy elite viewed taxes with a certain degree of ‘optionality’. Also, the private sector growth prospects for Ireland are already showing cause for optimism, in a way that Argentina was not, and to some extent still is not.

The real danger for Ireland is an inability to fund the government foreign deficit at anything like reasonable rates of interest. Having committed to stand behind the large Irish banks, the liabilities are substantial and growing, and the deposit base to support the banking infrastructure is negligible. At present the ECB is rolling over close to Euros 190bn worth of short-term funding to support the domestic banking base. It is this liability that is preventing the Irish government accessing the capital markets more than anything else.

As Daniel Gros points out again: “Given the scale of foreign assets owned by Irish residents there should be no need for the government to depend on the funds of the EFSF and the IMF, which are very expensive in both political and economic terms.” Mobilizing these private assets towards Irish bank deposits and Irish government bonds would not only serve the national interest but is in the economic interest of those making these investment decisions. GDP growth and continued low domestic taxes would be the virtuous circle that would result.

In practical terms, the incentives to ‘look to home’, should be in the form of tax relief on government bond investments or interest subsidies on deposits. The EU might protest that such incentives are akin to capital controls. I don’t know the legalities of the European Union, but certainly given how much German taxpayers have at stake in Ireland, and elsewhere, there will be a common appreciation for the idea that Irish people are taking on their own government’s liabilities.

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The current

According to the Office for National Statistics, the value of UK housing stock is a wee bit north of £4 trillion, a hefty portion of overall UK net worth which is £6.7 trillion. The vast majority of that £4trillion worth of property will be insured, in some form, against catastrophe.

I have just gone through the process of renewing our home insurance and it’s clear why so many desperate salesmen tried to call me immediately after entering my details on the gocompare.com website: premiums are expensive, and hopefully I won’t have to make a claim, so the premium is the insurance company’s to play with as they see fit. A “free-float” as Warren Buffett would call it.

Insurance is a great business. People are obliged to buy a policy if they want a mortgage, or if they want to drive a car, and there is a huge captive market to sell into. Houses don’t tend to fall down in bunches (not in the UK at least, touch wood) so payouts are reasonably predictable. If you do have to make a payout, compensate with a higher premium the following year. Market share is key – thus the success of those annoying market comparison websites.

Still, as buyers of insurance, we are collectively glad to have the peace of mind provided by an insurance company. The sellers of home insurance are regulated to ensure that if they are obligated to make a payout that there will be enough funds in reserve at the insurer to meet their obligations. As an insured homeowner, the tendency is not to think too much about that and to take it for granted.

In the wider financial markets, derivatives are traded in billions of dollars on a day-to-day basis. To the layman the concept of a derivative seems highly complex, obtuse even. Often they are not much more complicated than a house insurance policy.

In simple terms a derivative is a financial contract linked to the future value of the underlying to which it refers: a plane manufacturer who has a contract to build 6 planes in the next 6 months, may want to guarantee the price at which he is able to buy steel over that time period, so that he can budget accordingly. To cover the risk of the steel price rising, the plane manufacturer could enter into a derivative contract to insure himself against a significant rise. The contract would allow the manufacturer to buy steel at a fixed price, over the requisite time period.

Elsewhere, farmers might use derivatives to guarantee sale prices for their crops, international companies might use currency derivatives to guarantee exchange rates between countries they operate in, and banks might use interest rate derivatives to switch mortgage interest payments from floating rates to fixed. All valid uses of derivatives for risk mitigation.

On the other side of these trades are the risk takers; banks, hedge funds and insurance companies who assume and distribute these risks, or hold them in speculation.

Unlike the market for house insurance “derivatives”, regulatory oversight in the financial derivatives world is virtually nil. The “over-the-counter” (bilateral) derivatives market currently represents 90% of all derivative contracts (around €450 trillion) – an unbelievably large market and scarily untouched by regulatory oversight, until now.

Consider the very real notion of a New York based hedge fund selling credit insurance to a bank that owns a large portfolio of loans to US companies. Let’s say that the bank owns $1bn worth of loans to these companies and the hedge fund sells an insurance policy (a “credit derivative”) that will cover the first $100mm worth of losses if any/ all of these companies default. For taking on the risk, the bank pays the hedge fund a 10% premium per annum – $10mm. The hedge fund can theoretically use this money as it pleases – to pay the bonuses of its partners for example. If the proverbial hits the fan, and the loan portfolio sees losses of $100mm, the hedge fund needs to find $100mm to compensate the bank.

Under the status quo, in the unregulated world of derivative contracts, and of limited hedge fund regulation, the financial system relies both upon the hedge fund to manage its risks appropriately and for the bank that is buying the insurance to choose which hedge funds are appropriate to deal with. This is theoretically possible but with skewed incentives involved not necessarily likely.

The AIG story offers a perfect illustration of the problem. AIG had billions of dollars of insurance exposure via mortgage derivatives. The banks that were party to the mortgage derivatives (Goldman Sachs and Deutsche Bank for example), retained the right to jump in front of the creditors’ line by demanding immediate collateral under certain circumstances. Other than those banks, however, no one except AIG really knew how much exposure they had. Unsurprisingly, given this lack of information, the market extended far too much cheap credit to AIG.

As Andrew Feldstein points out in the FT: “To add insult to injury, some of AIG’s derivative counterparties, with superior knowledge of this riskiness, insured their credit risk by buying credit protection on AIG from market participants who were in the dark about AIG’s position. The ability to buy this artificially inexpensive protection enabled the banks to sell even more poorly disclosed mortgage derivatives to AIG.”

Even inside the AIG organisation, it was only really within the AIG Financial Products group, where these derivatives were being sold, that the risks were in any way understood. The rest of the group, as it turned out, didn’t think the Financial Products group were running significant risks. The beneficiaries of this heads I win, tails you lose strategy were the employees of AIGFP, who received big bonuses in the previous years for running these positions and essentially got away with it.

Sweeping changes to the world’s derivatives markets have been promised by lawmakers and regulators since the financial crisis began. Specifically, the demise of Lehman Brothers and AIG (in particular) highlighted the dangers of a poorly capitalised and poorly understood derivatives market.

The planned solutions to this lack of insight encompass four main areas:

Firstly, Capital Requirement Directive (CRD) proposals are pushing for as many as possible of these derivative contracts to be traded through regulated exchanges. The theory being that if one dealer or “counterparty” defaults, the knock-on effects can be measured, handled and absorbed by clearing house members.

Secondly, regulators will be nicer in terms of capital requirements to those who trade through exchange as opposed to “over the counter”. For that reason alone we should probably be looking to buy shares in the existing derivative clearing houses as their volumes will increase exponentially if this proposal is implemented. This is the premise upon which the Deutsche Borse-NYSE Euronext is based: if €450 trillion of OTC derivatives need to be processed through exchange, their volumes and profitability might well be heading in a compelling direction.

Thirdly, there will be requirements for all trades to be reported to regulators, with data repositories being set up to track the amount of exposure accumulated in both cleared and uncleared trades.

The fourth big push is that there will be explicit capital requirement for the credit valuation adjustment risk (CVA). Apparently two thirds of the losses stemming from derivatives during the financial crisis were a direct consequence of the deterioration of the credit quality of the counterparty and not necessarily triggered by the default of the counterparty.

To take the AIG example again, they sold credit insurance (credit derivatives) to Goldman Sachs and others on portfolios of mortgage bonds owned by Goldman at various points from 2005-2008. As AIG’s credit quality deteriorated the market value of the insurance policies owned by Goldman would have fallen significantly, even though AIG had not yet defaulted. Under the new CVA proposals Goldman would therefore have had to raise more capital against these mark-to-market losses. Instead, AIG’s demise left a gaping hole in Goldman and other’s balance sheets that could only be filled by a US government bailout, given the prevailing market contagion at that point in time.

Despite how complex and obtuse derivatives may appear to the layman, everyone should care about the outcome of this debate. Failure to address systemic flaws increases the likelihood of another financial crisis. On the other hand, new regulatory requirements will tie up capital that would normally go towards investments in growth and will also create disincentives to otherwise rational risk management decisions. The amount of capital that will ultimately be tied up in already undercapitalised banks remains to be seen, but with a $600 trillion market fractions are incredibly meaningful.

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Amidst the staggering news flow of the past few weeks, Ireland’s debt crisis and its status in the Eurozone, has been relatively low on the international agenda, but potentially epoch making for Irish people. Ultimately, Ireland will have to default on some of its obligations – they have grown (and will continue to grow) to the point where they are simply too great to sustain. The new coalition government needs to play their hand with subtle aggression. Burden sharing is a compulsory goal, but it should be sought in the first instance for good behaviour – follow through on public sector reform, austerity and hitting economic growth targets. The nuclear option of non-payment and euro withdrawal should be held in the background.

In an Irish Times article a couple of weeks ago: “How the World Sees Ireland”, citizens of some faraway and some not-so-faraway lands were asked what three things come to mind when they think of Ireland.

Raphaëlle Collomb, a young florist on rue de Bretagne in Paris: “The scenery, the open spaces, the sea, the cold climate. The people have a reputation for being friendly. Everyone knows about St Patrick. And the beer.” In China Li Linzi, 25, plumps for “beautiful dresses, U2 and grasslands”, while Li Ping, 55, says “Ireland is a small country, in some way related to England”. And a personal favourite: Zhang Yuehan, 27, says: “I know of Ireland’s ‘holy marriage’, where when a couple get married they can’t get divorced, they have to keep their promise for 100 years. Is that true? I love it, it’s so romantic.”

Ireland’s rising divorce rates over the past 10 years would suggest otherwise. The only true version of an Irish “holy marriage” is playing out in its relationship with the Eurozone, which is considerably less romantic.

The ECB and the Irish Central bank are collectively rolling over close to €190bn (115% of Irish GDP) worth of funding for Irish banks, which have no independent access to interbank or deposit markets. The expectations of a sovereign level default mean that the potential of attracting deposits in the near term is close to nil.

Secondly, a EU/IMF sponsored loan of over Euros 80bn is in place to cover Irish sovereign funding requirements for bank recapitalisations and planned public sector spending.

The recent results of the Irish bank stress tests clarified little. Irish banks’ loan books held €255.6bn worth of loans at the end of 2010 (loan to deposit ratio of 180%); with €190bn of that funded in the short term money markets via the ECB/ Irish Central bank there is little to be certain about. Under the requirements of the stress tests the banks must sell €72bn of assets by 2013.

According to the Irish Central Bank “Banks should be able to avoid fire sale of assets, but the deleveraging is likely to result in €13.2bn of losses.”

Two points here:

a) that loss projection is probably nonsense: it represents an average write down on assets sold of just over 18%. While there are quality international assets on the Irish banks/ NAMA’s books, even if that write down figure is correct the remaining loans will be an ugly agglomeration of mainly domestic mortgages.

b) €72bn worth of asset sales leaves another €185bn of “other assets” to find funding for. Irish negotiators were hoping to be able to announce with the recapitalisation that this ECB funding had been converted into some kind of medium term facility to allow the banks time to deleverage or find alternative deposits. But there’s been unexplained silence on this front so far.

It’s hard to believe that two years forward this process will leave the Irish state able to fund its banking liabilities independently. Consequently it’s hard to believe that further asset firesales won’t be pushed for, and these assets will be domestic mortgage loans. Who would be a buyer, and at what price?

In exchange for playing in this merry charade, bailout funds will be forthcoming and if Ireland behaves there may be interest payment reductions. In particular, if Ireland agrees to address its low corporate tax rate then there is the potential for a 1% reduction on the interest bill for the IMF/ EU bailout.

Allowing this holy marriage to continue in this way has the potential to lead to a multi-generational loss of competitiveness in the Irish economy, all-the-while not changing the likelihood of a partial or complete default on these obligations to our European friends.

Consider that a 1% drop in the interest burden would reduce the expected debt interest bill by around 600mm Euros. Not chicken feed, but unfortunately not game changing in Ireland’s context: the sizes are just too large: the projected interest bill on the IMF/EU loan is Euros 3.9bn per annum. That’s a big number – but the potential end size of the cost of banking recapitalisations is anybody’s guess, regardless of what the stress tests tell us.

The long and short of it is that Ireland will have to share the burden (sovereign states tend not to ‘default’) of these obligations at some point, and that the European Union specialism for “muddling through” won’t change that.

In order for the Irish coalition to understand the hand it is playing with it is important to understand a couple of technical aspects of the financial rescue mechanisms in place.

The current one – the European financial stability facility (EFSF) – will run out in 2013. It grants access to credit to countries in trouble, and may soon buy their bonds on the primary markets. These rank pari passu – on the same terms – with everybody else’s investments. That means if the troubled country defaults, everybody gets hit equally.

If Ireland were to default today, Germany and France would have to make good on their credit guarantees to the EFSF, which would be a political disaster. German conservatives would be apoplectic and haul Angela Merkel to the German constitutional court. As part of the muddling through principal, the creditor nations would therefore not allow a default until 2013.

In 2013, a new mechanism will replace the EFSF. It is called the European stability mechanism (ESM). The critical difference between the two is that its loans will rank senior to those of private investors, i.e. current and future bondholders. The idea is to make default possible, with only a moderate risk to the budget of the creditor nations. By 2013, the European banks should (fingers crossed for this bit) be in a better position than today to absorb big losses, or so one hopes. Happy days – end of crisis.

Unfortunately any half-witted bond trader can look forward. They know that once a country defaults, old and new bonds will be treated alike. In the Irish context, therefore, the access to the EFSF is a devils bargain. Bondholders and potential bondholders know that Ireland’s position is untenable in terms of its current obligations, so the threat of an organized default against them is on the cards in 2013 when the ESM is introduced, with particularly painful write downs.

The reason domestic banks can’t access deposit markets is because potential depositors know this. Consequently it’s hard to see beyond a continuing reliance on ECB overnight funds to cover daily interbank requirements, and they will have no choice but to push for future asset sales to get (some) of their money back.

For leaders in Brussels, this game will continue until the debtor country’s economy collapses under its debt burden, at which point the inevitable default will be very messy. If you are lucky, you are no longer in office by then, and you can blame your successor for the mess.

So what to do instead? For Enda Kenny and Michael Noonan, Ireland’s Taioseach and Minister of Finance respectively, the major task is to understand the hand they are playing with. For me, that means that they have to draw the firm conclusion that the current debt burden is too much and start stating that clearly.

This is a tight-rope walk for the Irish government, which is why “subtle” aggression is what is required. As former IMF deputy-director Donal Donovan points out: “You can hardly burn the bondholders in the morning and then expect in the afternoon the same broad class of lenders to come and give new financing to these banks.”

Donovan predicts that Ireland could get a third of its debt ‘restructured’ but said it had to keep to its side of the bargain, continuing with internal adjustments and driving down public sector pay to bring it into line with the private sector.

“Debt restructuring is a reward and a reward which is held back for quite some time until the person that’s getting it or the country that’s getting has done enough to have earned it,” Donovan said. “It sounds rather calculating and cynical, but honestly this is how much of the world works on these matters.”

The European Central Bank would eventually come around to the idea of writing off some of Ireland’s debt, he said, because by 2013 external agencies like the IMF were “likely” to deem Ireland’s debt to GDP “unsustainable”. Ireland’s debt to GDP ratio is expected to rise to between 115 and 120 per cent in 2013-14. They may well get there quicker – and perhaps Enda Kenny should be pleading more to the IMF than to Sarkozy and Merkel.

“The IMF has no problem with the principle of debt rescheduling – I think the EU has more difficulties with the idea of rescheduling. They are new to the game, they’re worried about the reputational loss to the euro,” he said as well as worried that “other countries could be tempted to follow some more profligate policies if they feel a debt rescheduling exit if they get into trouble”.

“For these reasons – I’m not saying they are good reasons, but they are the reasons – the EU has been much keener to muddle through on this, rather than take definitive steps early. This isn’t very attractive intellectually but we live in a world of political institution constraints, so I think this will continue for some time.”

Clearly there are many moving parts, and Ireland is a provincial outpost in European terms. The only course of action is for the new government to push for public acknowledgement that the debt burden is too big to sustain, and seek restructuring concessions as early as possible. The concessions should come not because of belligerence, but because of a clear commitment to reform and economic growth.

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I’m reading a book at the moment called “Bounce: How Champions are Made”. Not exactly autobiographical, but I’ve got a few years in the tank left to work with. The book’s author, Matthew Syed, focuses mainly on sporting excellence and how it is achieved, but has many transferable stories for all walks of life. The basic gist of his message is that talent is overrated, and hard work and persistence are more crucial. Furthermore, societies or organisations that focus solely on praising talent rather than work ethic and persistence can have some very unfavourable outcomes. Syed paints a picture of these problems in both a sporting and general life context.

In 1998 a lady called Carol Dweck took four hundred eleven-year-olds and gave them a series of simple puzzles. Afterwards each of the students was given his or her score, plus something else: Six words of praise.

Half of the students were praised for intelligence: “You must be smart at this!” The other half were praised for effort: “You must have really worked hard!”. The goal was to see how these alternate phrases could make a measurable impact on persistence and performance in future tasks.

After the first test, the students were given a choice of whether to take a hard or an easy 2nd test. Two-thirds of the students praised for intelli gence chose the easy task: the inference being that they did not want to lose their ’smart’ label by potentially failing at the harder test. Amazingly (and this test was repeated with all sorts different sample groups with similar results) 90% of the effort-praised group chose the harder second test: the inference here being that they wanted to prove just how hard-working they were.

Next the students were given a test so tough that none of them succeeded. Once again, there was a dramatic difference between the ways they responded to failure. Those praised for intelligence interpreted their failures as proof that they were no good at puzzles at all. The group praised for effort persevered on the test far longer, enjoyed it far more, and did not suffer any loss in confidence.

Finally the experiment came full circle, giving the students a chance to do a test of equal difficulty to the very first test. Strikingly, the group praised for intelligence showed a 20% decline in performance compared with their scores the first time around, even though it was no harder. The effort praised group, on the other hand, increased their score by 30%.

Failure had actually spurred them to better performance. And as Syed points out: “All of these differences turned on the difference in six simple words spoken after the very first test.”

In Dweck and Syed’s views, “mindset frames the running account that’s taking place in a person’s head”. It guides the whole interpretation process, for better or for worse.

One of the final outcomes of Dweck’s praise experiments is perhaps the most striking – and disturbing. At the end of the tests she told the students that she would be conducting the the same study at another school and that the children there might like to hear from students who had already taken the test. She gave the students a sheet on which they could record their thoughts along with space where they could record how many problems they had got right.

When looking at the children who were praised for effort, almost all of them told the truth about their own performance. Only one child in the group had doctored his score. But in the group praised for intelligence, an amazing 40% had lied about their scores. Doing well was so important to them that they felt compelled to distort their performance in order to impress an unknown peer group.

Syed, via Dreck, takes this theme into looking at corporate cultures. In 2001 three senior executives at the prestigious management consultancy, McKinsey, published a book called “The War for Talent”. The key tenet reflected a deeply held McKinsey philosophy: that talent is what ultimately determines success and failure in the corporate world; that pure reasoning ability matters far more than experience based “domain specific” knowledge.

“Don’t be afraid to promote stars without specifically relevant experience, seemingly over their heads”, the book comments. On this strict basis I would advise anyone requiring brain surgery to avoid any McKinsey advised hospitals. Similarly if there is a fire in my house I’d happily take the 20 year veteran firefighter over the talented fresh faced Oxford graduate with a Phd in thermodynamics, ‘talented’ as he might be.

To take a real world example, Alex Ferguson’s management of Manchester United football club over the past twenty years would be a clear testament to the right collective work ethic as opposed to heaping praise on star individuals. Many a self-styled star with the wrong mindset has been passed on by Sir Alex, and given the trophy cabinet he has amassed his approach clearly has some merit.

Although the McKinsey “War for Talent” approach provoked debate within corporate America, one company took the concept further than most. Malcolm Gladwell wrote in the New Yorker magazine: “Enron was a company where McKinsey conducted twenty separate projects, where McKinsey’s billings topped $10million a year, where a McKinsey director regularly attended board meetings, and where the CEO himself was a former McKinsey partner…Enron was the ultimate ‘talent’ company.”

Carol Dweck (she of the student’s tests) also comments:

“Enron recruited big talent, mostly people with fancy degrees, which is not in itself bad. It paid them big money, which is not that terrible. But by putting complete faith in talent, Enron did a fatal thing: it created a culture that worshipped talent, thereby forcing its employees to look and act extraordinarily talented. Basically it forced them into a fixed mindset. And we know a lot about that. We know that people with the fixed mindset do not admit and correct their deficiencies.”

Remembering that 40% of the students praised for intelligence actually lied about their score on the test, in the Enron case the ‘fixed mindset’ had made the public admission of their real result intolerable. Now consider the mark-to-market accounting and SPEs at Enron. How Enron spent weeks leading up to each quarterly earnings announcement figuring out ways to conceal any bad news. Employees became paranoid about admitting to any mistakes, fearing that they would be written off as untalented and fired from the company. The fixed mindset that the culture had created came to permeate and define the daily existence of the executives and employees.

Gladwell picks up the story: “They weren’t naturally deceptive people…they simply did what people do when they are immersed in an environment that celebrates them solely for their innate ‘talent’. They begin to define themselves by that description and when times get tough and that self-image is threatened, they have difficulty with the consequences. They will not take the remedial course. They will not stand up to investors and the public and admit that they were wrong. They’d sooner lie.”

Far be it from me to accuse the entire investment banking community of acting this way, but the ‘natural talent’ employment path is one pursued by virtually all of the investment banks I can think of. The demise of Lehman would tell a similar story about a senior management who had never been forced out of the fixed mindset; admitting and correcting deficiencies would have been weak and culturally unacceptable. As an organisation this management mindset is certainly not unique.

Consider the countless other bankers who find it strange that the general public would dare to question whether they are worth the bonuses that they are paid. The mindset of the average recipient is fixed and says: “Of course I am, I earned it”. Similarly those who question the fairness of the notion of taxpayers saving many banks from capitulation, find it strange that the response from the banks is again fixed and along the lines of: “Look, we are critical to the functioning of the economy – without us there is no economy.”

As I reflect on reading Syed, Gladwell and Dweck’s thoughts it’s clear that I too think in the talent centric way that is potentially misguided. As a recent second-time father there are lessons here. My internalised goal as a parent is to foster passion and excitement for life in our two children, in whatever fields they chose to follow. In theory that sounds quite simple.

When they are dwindling (who knows) at the bottom of their Maths class, or being picked for the ‘C’ rugby team will this enthusiasm for their hard work ethic and passion shine through as a parent. It will take a strong will given my somewhat fixed mindset, and I can only hope I am strong enough to praise and encourage in the right way. Luckily my wife is already good at this; she did give me Syed’s book for Christmas now that I think of it.

How does your company treat you? Is it growth minded? Are the lessons of failure lost amongst the P45s? Or as a parent, educator or manager, do you praise talent and achievement or effort and passion. Is failure the end or the start of a process?

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Gordon Brown went as far as selling off the “family gold”, in what could only be described as one of the worst trades in the history of trading. In 1999 he offloaded 400 tons – half of the UKs gold reserves at an average price of $275 an ounce. The price he achieved was a commendable 30-year low point in the market – now referred to as the “Brown Bottom”. The current gold price is around $1400 an ounce – given the extent of the budget deficit those 400 tonnes could have been quite useful.

The vast majority of the time, as Gordon Brown so radically demonstrated, I’m of the view that the best way of handling businesses and assets is in the private markets. So by-and-large, I would tend to agree with the sentiment of Thatcher’s great privatisation movement. Most of the time the private sector is better equipped to judge the best use for assets and the best ways running business, rather than civil servants in Whitehall, or wherever else they may reside.

Over the Christmas period as millions of people tried to make their journeys “home” – to Dublin, New York, Sydney or wherever else – the universal effectiveness of privatisation, however, was surely called into question. The busiest airport in the world, Heathrow, was at a standstill for several days, along with Gatwick and many of the other airports around the UK. Heathrow, amongst others, is owned by BAA Ltd. (British Airports Authority). Gatwick was also a BAA asset until recently, when the government forced a sale on the basis of the ownership being “anti-competitive”.

BAA was first established by the British government in 1966 to take responsibility for 3 state-owned airports – Heathrow, Gatwick and Stansted, and in the following years acquired the responsibility for Glasgow, Edinburgh, Southampton and Aberdeen Airports. As part of Thatcher’s moves to privatise government owned assets, the Airports Act was passed in 1986, which mandated the creation of BAA plc as a vehicle by which stock market funds could be raised.

In July 2006, BAA was taken over by a consortium led by the Spanish group Ferrovial, who paid £10.1 billion for the privilege. Ferrovial, and its consortium of banks performed a leveraged buyout – placing a huge chunk of (at the time) very cheap debt onto the balance sheet of the company. As it stands BAA Ltd. has £9.9bn worth of debt on its books and this figure is forecast to rise to £10.6bn in 2011. Interest payments on the debt this year have risen to close to £520mm, with 2010 EBITDA (earnings before interest, tax, depreciation and amortisation) expected to be around £970mm – so net income is less than £450mm.

Over the coming years interest payments on BAA’s debt mountain are only likely to increase, as credit is less and less available, and at higher cost than before. As the Daily Mail piece on the subject says with atypical understatement: “Ferrovial is widely believed to have overpaid for the deal”. It’s hard to disagree with such profound sentiment.

The consequences of all this manoeuvring became evident over the past couple of weeks. Woeful underinvestment in infrastructure – snowplows and deicers for example – leading to the shambles that was evident for so many people. I’m not saying that things would necessarily be different under complete state ownership, but at least the government would have some power to act with the bigger picture context in mind.

As Adam Marshall, director of policy at the British Chambers of Commerce, said: “When our infrastructure fails to cope with weather events, it reduces our attractiveness to inward investment in the UK as well as tourist revenues.” The economic gist of what he’s saying is that there is a signficant positive externality to having a well functioning airport infrastructure, so it’s potentially worth subsidising this in order to reap these tourism and inward investment revenues that would accrue to UK PLC.

Clearly these external benefits do not accrue not directly to BAA shareholders, or other stakeholders, so Ferrovial (which has failed to properly capitalise BAA Ltd.) will continue to underspend. Their main focus is on trying to keep all costs down – debt interest being the biggest one – so that the profitability accruing to their wafer thin equity is as intact as possible. BAA Ltd. is not in breach of any of its covenants on its huge debt pile, so from a stakeholder perspective all is reasonably rosy at Heathrow, Stansted etc. regardless of how much customers and airlines hate the places.

It should come as no surprise that there is still considerable state ownership of airport assets around the world, for these very reasons. They are either under complete state control or local or national government has a substantial stake.

The United States is hardly a socialist country but many major airports are considered too important to be completely entrusted to the private sector. JFK, for example, is operated by the Port Authority of New York & New Jersey. Logan Airport in Boston is operated by Massport, a body which is answerable to the governor of Massachussetts. Similarly the French State owns holds 60% of the shares in Charles de Gaulle airport, and 51% of the shares of Frankfurt airport are in public hands.

If you want to understand the lack of capacity to deal with the snow and ice, it is not down to some unique British character trait. The inadequate investment is down to owners being reluctant to make capital investments which aren’t optimal for their own stakeholders.

Generally speaking, I have no problem with that. When it comes to airports perhaps there is a case for at least keep a few knives and forks from the family silver. Happy New Year.

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A free education, like free healthcare or public transport, as a concept is a misnomer – as with the clean up bill for Trafalgar square protests – someone has to pay. The current conundrum (as with all spending decisions) is whether society as a whole should pay for university education or whether students who benefit from its rewards (and the 3-4 year drinking session it entails), should foot the cost.

It’s not a simple question to answer. In reality both society and the individual do benefit from more education. On balance, who benefits the most, however, is more down to individual circumstances, so it is hard to draw a general conclusion. What is clear though, is that any argument from the student protesters has been watered down by a minority of disinterested anarchists, and I feel for those who are trying to make a valid argument in a legitimate way.

In the long-run the approach to education should reflect where workers are needed in tandem with what the broad values of a society are. Trying to achieve one without the other is impossible over time. It’s true that there is a shortage of science and maths graduates, but society clearly benefits from historians and english literature graduates, albeit in a way that economists find intangible, and therefore hard to measure (they hate that). It’s harder for society to measure the value of an Oxford graduating Art Historian who sets up a pioneering gallery in the West End, versus a immunologist who makes commercially viable breakthroughs in cancer research. These value arguments are difficult because the comparisons are not like-for-like, but both roles serve their purpose in creating the sort of society that I want to live in.

There are, however, certain “known knowns” as Donald Rumsfeld would call them. The UK and Ireland are small, open economies that are small pieces of the patchwork quilt that makes up the global economy. Since the end of the Second World War the world has been on a globalisation spree – opening up markets and reducing barriers to competition almost everywhere on the planet. There are not many workers in the world who know what it is like to work in a “protected” industry and as hard as unions try in some parts of the world, they are struggling to justify protecting “workers rights” in one country when that merely cannibalizes the competition from workers in another developing country.

The benefits of globalisation are all around us – my iPhone reads “Designed by Apple in California, Assembled in China”. Alternatively it could read: “High tech geeks in Silicon Valley came up with this, hired a lawyer to protect the intellectual property, then outsourced the production to the smart, resourceful and abundantly cheap Chinese workforce. Consumer the world over was happy because end product was smart and cheap. Enjoy!”

Being a consumer in a globalised economy is great – lots of smart and cheap products competing for your custom. The flip-side, however, of being a worker in this world is tougher. Competition is pushing labour costs down, and if you are in a high cost economy like the UK, you need to be creating something really special to warrant someone paying for your high input costs. Apple can justify its high Californian input costs because they are so specialised, but manufacturing costs are reduced by choosing to outsource that part of the process elsewhere – as they should be in a global marketplace.  Everyone trades on their own competitive advantage.

Up until the start of the financial crisis over two years ago, the world economy had enough “aggregate demand” available to support the economic system as it stood. From US consumers spending on their credit cards, to debt fuelled Irish property tycoons pushing up demand for top end housing, there were enough consumers to buy things, even if the methods of financing were akin to a Ponzi scheme. Companies were hiring because of this, and the virtuous circle was complete.

As Bill Gross points out in his most recent monthly commentary on world economic matters: “The global economy is suffering from a lack of aggregate demand. In simple English that means that consumers are not buying enough things and that companies are not hiring enough people because of it. Growth slows down, especially in developed as opposed to developing countries, and the steel mills of Allentown, USA and Sheffield, England close down.”

Confronted with this vivid picture, developed world governments can put in place policies to temporarily dampen the economic effect. Quantitative easing, low interest rates, and increased public spending all serve to artificially bolster consumption while failing to address the fundamental problem of developed economies: Job growth is moving inexorably to developing economies because they are more competitive.

As Gross points out: “The constructive way is to stop making paper and start making things. Replace subprimes, and yes, Treasury bonds with American cars, steel, iPads, airplanes, corn – whatever the world wants that we can make better and/ or cheaper. Learn how to compete again.”

Given that context, the goal of the education system in the UK and Ireland (and the US) has to be to contemplate both what workforce is required to compete in that global economic context, and what is most conducive to creating the society we desire. All the while, we need to remember if we don’t get the former right (i.e. we don’t have an employable workforce), then the latter is an impossibility.

Finding the right balance between the two is difficult. In a recent debate on the matter in the House of Commons, an SDLP member, stated that: “The whole future of high tech, high value added economy that we all subscribe to depends on high quality 3rd level education that is accessible to all.” Accessible to all, I agree. Available to all, as I think he also implies, not necessarily.

In Ireland, Intel employs thousands of people, in large part because of the nano-sciences department at Trinity College, Dublin. That department is ranked number 2 in the world for that cutting edge subject, on a research budget that is 1/300th the size of the number 1 ranked university (Stanford). Intel doesn’t employ thousands of nano-scientists in Ireland, but it does hire thousands of people on the basis of its access to a handful of the truly world class exponents in this field. If the nano-science field was “available to all” would the standards of the few who excel be as high? Would Intel hire those thousands of nano-scientists if there were lots of them, but they were mediocre? Surely not. Similarly, if funding was reduced for this research department, so that we could ensure that any 18 year old who wanted to could study golf course design or even english literature (both valuable in their own ways) would Ireland be well served given its position in the global economy? I think not.

The UK missed a trick in the early 1990s when the polytechnic concept was thrown out, and these institutions were turned into 3rd and even 4th rate universities teaching academic subjects like History and English Literature. Both of these subjects (I reiterate) are very important, but if you have achieved 2 E grades at A-level, you have not earned the right the study them for 3 more years at the taxpayers expense. If you choose to do so, then you should take on that burden for yourself. Current government proposals allow the individual to make that decision, but with the health warning that they are taking a lot of debt on where the economic return may not be commensurate.

Government funding should and will be high for social sciences and the Arts at the very best institutions. Elsewhere the focus needs to be on producing educated young people who are going to be valuable members to the economy that we will be in. Polytechnics or technical colleges are the ideal alternative to pursuing an academic 3rd level degree.

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There is a British and Irish game regularly played at children’s parties, or at least it used to be before Nintendo Wii and Playstation came along, called “pass the parcel”. In this game the children sit in a circle passing a heavily wrapped parcel around while music plays in the background. When the music stops the one holding the parcel gets to remove a layer of wrapping off said parcel. In the final round the last layer is removed and the child holding the parcel gets to keep whatever gift is inside. In this game, the goal was to be this person, though, in hindsight, the anticipation was more enjoyable than anything else.

There is a similar game currently being played by consenting adults – in fact the leaders of our global economic system. Again the anticipation is killing me, but I don’t think it will be an enjoyable end. So far this particular game has been quite a long one – it started around September 2008 when Lehman Brothers collapsed in a heap. Over the twenty-odd years previous to that date the world economic order spent some considerable time wrapping the gift that this gigantic game would be played with. Instead of paper-based wrapping, debt was the layer of choice, and inside all of this wrapping lies a present nobody wants to be holding at the end of the game.

Since September 2008, when the game commenced, the debt laden parcel has done the rounds. Firstly, no income, no job, no assets (NINJA) mortgage holders started posting the keys to their negative equity strewn houses back to American banks. These banks then passed these unfortunate mortgage problems onto the world’s banks, pensions funds and insurance companies, to whom they had previously sold securitisations of these loans. Those who hadn’t sold this problem ahead of time then passed them onto the US government or to Fannie Mae and Freddie Mac, or passed on their problems by defaulting like Lehman Brothers.

In Germany, the UK and elsewhere these now undercapitalised American-mortgage-holding institutions were either “consolidated” into other larger and apparently stronger financial companies, or if they had really had a shocker they were directly nationalised, i.e. passed onto the state balance sheet to be funded by the taxpayer.

When these consolidations took place (typically forced), it took a short period of time before the larger organisations realised that they too weren’t able to support these new gifts when combined with the gifts they already had on their books. Governments the world over realised that they could slow down the pass the parcel exercise if they inflated asset prices and made those holding the parcel feel better about their situation. They lowered interest rates, from near zero to zero, and in some cases below zero. This worked for a time. Interbank lending picked up, and valuations of assets stayed steady for a while.

The parcel was relatively stationary for a time. Then governments around the world started to tally how much debt they had actually taken on as part of the initial bailout, and the markets were shocked. How would we ever be able to pay all of this money back?

We won’t, was the conclusion, so we need to keep passing. Those that could, passed the buck by the politely titled ‘quantitative easing’. The UK and US are pursuing this path. The buck is being passed to the next generation, who will have a huge potential inflationary problem to contend with and to current bond holders (China for example) who are funding this largesse. Furthermore, quantitative easing and other forms of competitive currency devaluation are part of the toolset used to grab a larger piece of dwindling global aggregate demand. Weaker currency leads to more competitive exports, and higher exports mean higher growth rates. The parcel is passed on to the next generation of workers, who’s exports will create the tax revenue to cover the debt mountains.

Elsewhere where these fictitious tools aren’t available (peripheral Eurozone countries) the parcel is being passed. For example, from Irish bankers and their bondholders via Irish taxpayers and onto German taxpayers and other “core” countries. If only the passing in the Irish rugby team could be so fluid.

“What’s next when all of the periphery has passed its burden?” is the question the markets are currently asking. When Spanish banks start to come clean about their mortgage problem and ensuing funding situation, the Spanish government will have a choice: pass the burden on to the bondholders in these banks or nationalise them and get a sovereign level bailout. In the first instance Spanish bank bondholders are probably based in other parts of the Eurozone, so defaulting on these bonds would create yet another potential systemic problem, which means it won’t happen.

A sovereign level bailout of Spain is potentially the last layer of wrapping in the 2 year pass the parcel extravaganza. Unfortunately, at that point we may all collectively be holding the tin can that is the prize at the end of the game.

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