Ireland – a microcosm of the Great Deleveraging

It’s been a bad week (again) for Ireland on the economic front. Statistics showed that Ireland is officially the first country to show signs of a “double dip” recession with the economy shrinking 1.2% in the 2nd quarter. To coincide with this news, the Taoiseach Brian Cowen, was seen doing the rounds at the National Ploughing Championships (seriously) – which is presumably a better place to be than doing early morning, hungover, radio interviews. 

This latest economic statistic has put further pressure on the Irish government bond market, pushing the yield on 10 year bonds above 6.5% and adding to the growing bill that Irish taxpayers will have to pay for the country’s indebtedness.

At the epicentre of Ireland’s economic woes is a banking crisis, and more specifically an almost unmanageably large crisis relating to one single bank – Anglo Irish Bank. While many international bloggers and commentators seem incapable of identifying this institution correctly – interchanging it with the other AIB, Allied Irish Bank, it is Anglo that is at the centre of Ireland’s problems.

Anglo Irish Bank, not to put too fine a point on it, is a basket case. S&P downgraded Ireland’s credit rating a few weeks ago on the basis of its estimates of the ultimate cost to taxpayers of recapitalising the country’s banks. The agency suggested that the cost of the bailouts could amount to close to €50bn, almost twice the government’s current estimates, with almost €40bn of that figure to be attributed to the bailout of Anglo Irish Bank. Anglo’s current CEO Mike Aynsley, who has had the unedifying job of identifying the staggering lending indulgences of past management, reckons the true figure will “not be more than €25bn”.

That real figure depends on the “haircuts” the government will apply to loans that are being transferred to the National Asset Management Agency (NAMA) under the government’s bank rescue plan. But how does one realistically value a loan, for example, for €288mm made by Anglo on the development of area in Dublin once used as the site of the Irish Glass Bottle Company.

The land was valued at €20mm in 2002 and the €412mm paid for the site in 2008 was based on some incredibly ambitious business model calculations. As the country delevers and deflates, the chances of development are a remote concept – but in any sense I’m sure the haircut on this loan when it was transferred to NAMA was a significant overpayment versus a “real” free-market price.

Even though Ireland has suffered deflation for 22 months consecutively, asset prices remain inflated by the credit boom of the previous 15 years, but the correction mechanism of deflation is incredibly damaging in the short-run. Had Ireland not been part of the Euro, it’s old Punt would have devalued over the past 2 years allowing for a quicker export-led recovery. For the UK, this has been a valuable part of the recovery process – currency deflation is far easier to manage than domestic price depreciation. Deflation postpones investment, increases the savings rate and as the Japanese have shown for years is massively economically destructive.

Ireland’s economic situation is not unique – it’s just a microcosm of the potential impending situation elsewhere in the world. The credit bubble of the past 20 years, spawned by loose monetary policy of successive central bankers has led to massive price inflation across a whole host of financial assets. Take for example – the total net worth of the UK, including financial assets, at the end of 2009 was £6.7 trillion, according to the Office for National Statistics. Within that figure the value of most valuable asset, housing stock, was just over £4 trillion. According to the ONS, the value of this housing stock on an inflation adjusted basis was just under £300bn in 1948.

Banks who lend against the value of this housing stock increased their lending exponentially as the underlying asset prices have increased. The money multiplier effect has increased the whole economic system’s leverage against a stock of assets that hasn’t changed in intrinsic value anywhere near as much as prices suggest.

In Europe bank capital is now equivalent to less than 10% of assets, compared with around 25% at the beginning of the twentieth century. Today banking assets (loans + deposits) in the world’s major economies are equivalent to around 150% of those countries combined GDP. As asset prices fall and banks are forced to hold more capital in reserve in the future there will be a significant forced delevering of the financial system, which left to its own devices will create significant deflation.

The ambition elsewhere is to avoid a Japanese, or now Irish type situation. The price of gold hit an all-time high this week, close to $1300 an ounce because the Federal Reserve said that it was “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” Ben Bernanke, as an expert on the Japanese deflationary situation, will do anything to avoid the same path.

In the UK Members of the Bank of England’s Monetary Policy Committee also expressed concern that slower growth in the UK might require further stimulus, but indicated the need for such measures had not yet arrived, as trend inflation is already running significantly above the 2% target rate.

The reality in my view is that the world needs to delever, banks need to recapitalise themselves, and sustaining the status quo through money printing is an entirely understandable short-term patch job on a financial system that lost the plot over the past 50 years. For the likes of the US and the UK who have control of currency and monetary policy we will continue to see competitive devaluation, through quantitative easing and continued all-time low interest rates. The ability to maintain a steady course between deflation and significant inflation, however, is getting trickier and trickier.

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