October 6, 2002

Credit reaches its expiry date

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Further south in Argentina, state governance has ground to a halt, and people are organising into small local communes not unlike those workers’ co-operatives seen on the Republican side in the Spanish Civil War.

Up north, the Yankees are in disarray as former scions of industry go on trial and the stock market does a passable impersonation of a weapon of mass destruction.

The Dow continues to head south, with Alan Greenspan, the one-time wizard with the Midas touch, experiencing a torrid time.

Throughout the entire continent of America, from Portland to Patagonia, serious changes are afoot.

What, you might ask, has all this got to do with us here? Everything.

More than any other country, Ireland was a beneficiary of the late 1990s golden era for global capitalism. It profited hugely from economic proximity to the United States. A unique set of financial circumstances occurred in the 1990s, which allowed Ireland to surge, the US to experience the most dramatic financial bubble in years and Latin America to flirt with an IMF-backed economic experiment that has now ended in tears.

It is credit that links these three diverse areas of the globe — free, fully available and indiscriminate credit. The 1990s saw the biggest peacetime movement of money around the globe; such expropriation of cash from one country to another was hitherto limited to wartime. As a result, we experienced a significant change in the world distribution of savings.

Firstly, the Uruguay Round trade talks under the auspices of Gatt in 1989 reduced all credit controls around the world. This allowed credit to move from one country to another.

Secondly, the demographics changed. Over the past decade, Germany and Japan have become perceptibly older. Older societies spend less and save more, grow less quickly than younger ones, and typically run huge current account surpluses. In the past, this surplus cash was trapped in the host countries, but in the 1990s it could go wherever the returns were highest.

In Europe, German unification masked this underlying demographic shift, and European interest rates remained high, to attract extra capital to pay for the cost of integrating East Germany.

By 1994-1995, the unification boom had given way to gloom in eastern Germany. Demand for capital collapsed to reflect the demographic reality of not only Germany, but France and Italy as well. The grey societies of western Europe settled back into their traditional pattern of slow growth and low interest rates.

From a financial perspective, German unity was an aberration — a blip in a long-term European trend towards lower interest rates and a surplus of capital.

So where did all the money go? It went to high growth areas such as Ireland, the US, south-east Asia and Latin America. In Ireland, we got the perennial free lunch. Because our currency was practically tied to Germany’s, we could borrow as much German capital as we wanted with no risk to ourselves.

And did we borrow? In the past five years, the domestic credit explosion here has been a direct transfer of funds from the average Gunter to the average Paddy. A cynic might conclude that we have borrowed German money from German banks to buy gleaming new German cars. However, the point remains that Ireland, whose population boomed in the late 1960s and 1970s, has profited uniquely from a tie-up with Germany, whose population growth has been falling since in 1976.

Not only did German cash flow into this country, but the property market acted as a unique multiplier. Due to the structure of the Irish financial market, houses became a type of gold standard, where new credit caused the price of houses to rise initially, leading to more credit being created, leading to yet more credit, and so on.

The housing market in Ireland has acted as a unique accelerator to the process of credit creation, amplifying the impact of new credit at every stage of the housing market boom.

The US had a similar credit boom. It borrowed cash from Germany, Japan, and indeed anyone who would lend it money. Today, the US needs to borrow over $1 billion a day to balance its books. By 2007, it will owe over 50 per cent of its GDP to foreign lenders.

The influx of capital in the US was also amplified via the use of derivatives in the financial markets, borrowing against higher real estate values, and leverage in the dotcom boom.

All these factors also led to a surge in the dollar, a huge increase in indebtedness, and an economic “miracle”. Again, the crucial aspect was the population. In the US the relatively youthful population demanded credit — and the ageing Germans and Japanese obliged.

Latin America experienced a similar wall of money entering its economies, driving up prices and giving people the impression that an economic “miracle” was occurring. But there were huge differences between Ireland and the others, the key one being our political and currency union with Germany.

EMU took away the currency risk, so German lenders did not have to worry about our currency devaluing against the mark. Thus, they could lend and we could borrow, with apparent impunity.

Not so the Latin Americans. Countries such as Argentina and Brazil had been beyond the pale up to 1994. Then they introduced systems dictated by the IMF.

Initially, cash came cascading into their economies and they experienced an Ireland-style mini-boom. But over time, investors got worried and cash began to flow back out.

Argentina imposed a rather ludicrous straightjacket upon itself to convince lenders that the country had changed.

In the process it experienced 35 straight months of recession. In the end, last December the entire house of cards came tumbling down, resulting in nationwide impoverishment.

Mindful of Argentina’s strict adherence to IMF rules and its subsequent ordeal, Brazilian voters are concluding that enough is enough.

As all the credit-driven booms of the 1990s — Ireland’s, the US’s and, most dramatically, Latin America’s — begin to founder, it seems clear that one of the great economic eras is coming to a close.

Let’s hope that the resulting swing of the political pendulum will be less dramatic than experienced elsewhere.