July 30, 2012
In terms of reading the economic tea leaves, last week’s cup of data has left behind a perplexing residue, with some good bits, some bad bits and lots of confusing bits, which could go either way. However, it is a crucial week because the evidence suggests that something very odd is happening in Ireland. The Irish bond market is decoupling from the Irish economy. That sounds weird, but let’s dig a bit to explain.
The news from the financial markets – Ireland being able to borrow again – is unambiguously good. There are a few gripes, like the interest rates, but it would be churlish not to see this as a positive – and indicative of a likely bank deal which will see a dramatic easing in the overall debt position of the state.
Obviously, there is a long road still to go, but the markets clearly believe that the bank debt mutualisation deal hinted at in Brussels last month will be delivered.
So far so good, but at the same time, the data from the real economy was awful, and the news from the banking system, as well as local credit conditions, is equally desperate.
In another development which will form the background music to the next few months, ECB president Mario Draghi has signalled that he is going to take the Germans on and has fired the opening salvos in what will prove to be a titanic battle for the hearts, minds and balance sheet of the ECB. He will buy government bonds directly.
So it has been quite a week.
Let’s deal with the decoupling idea. For the markets to come in behind a bond issue of a country still in the IMF’s emergency ward would usually mean that the patient is making a robust recovery. But this is not the case at all. In fact, the evidence presented last week shows that the Irish economy – the real economy, where most of us work – is still getting weaker.
This should cause yields – the interest rates on our bonds – to rise and the markets to say: “Thanks but no thanks, we’ll pass this time.” But the opposite has happened. How can that be?
Lets examine this week’s real economy tea leaves.
For some years, this column has been making the point that we are in a balance sheet recession. Many Irish peoples’ balance sheets are broken because, on the one side, they have assets – houses, land and apartments – which are falling in value but, on the other, they have debts which are fixed.
At a time when income is falling due to rising unemployment and taxes, this means the debt burden is getting heavier every day relative to income.
As a result, people with savings are saving even more. Those with debts are trying to pay them off. The same goes for companies. Ireland’s savings ratio – the amount the household and corporate sectors are saving – has exploded.
Latest data for the first three months of the year – looking only at the household sector – shows that Irish people are saving more and more, or paying back more and more debt, or both. The savings rate has increased markedly, from 11.2 per cent of gross disposable income in the first quarter of 2011 to 14.2 per cent in the first quarter of this year.
This was the highest first quarter savings rate registered since the figures were published. Just to give you an idea of the shift: in 2007, we were borrowing 5 per cent more than our incomes.
This causes an old-fashioned liquidity trap, where monetary policy doesn’t work and where it doesn’t matter how low interest rates go – because people aren’t borrowing and banks aren’t lending. The liquidity trap is made worse by vicious deleveraging, which is destroying asset prices.
Given that, even in an open economy like Ireland, most of us are employed in the domestic sector, your spending is actually my income and my spending is your income. My income is also the root of my savings. But, as Keynes observed in the paradox of thrift, if we all save at the same time, who is spending. If no one replaces our spending, then demand will fall and fall.
Retailers react to falling demand – retail sales in June fell by a huge 5.5 per cent year-on-year in June – by cutting prices to coax us to spend. But the very fall in prices convinces people that prices will fall further and the bargains will come next month, or next year. So the laws of economics are turned on their heads. When prices fall, demand doesn’t go up, it goes down.
This causes unemployment to rise. Last week, CSO figures showed that over 82,000 people under the age of 25 were out of work in April 2011. This means that 39 per cent of people in the 15-24 age group are out of work. This comes on top of data last week on long-term unemployment, which rose to just under 200,000.
People don’t want to borrow because they have too much debt, and banks don’t want to lend because they have too much bad debt. Yet the deleveraging is destroying their capital base, too.
Again, the paradox is that deleveraging my balance sheet might make my position better, but when we all deleverage at the same time, we drive down asset prices further, demanding yet more deleveraging.
In the Irish banking system, we can see the paradox of deleveraging mainly via the fact that the ECB is presiding over the lowest interest rates ever, yet AIB has just increased its mortgage rates. The reason for this is that the banks need to raise margins on any new business for the years ahead to accelerate their own rate of deleveraging. The banks have to raise deposit rates to get more money in, and they have to raise margins across the board to make sure they are making money.
So the data from the real economy are terrible, yet the bond market is open for business. Why is this?
A rational conclusion must be that the financial markets see relations with the ECB as being much more important. If the ECB is going to open its balance sheet and buy bonds, which is the logical conclusion from what Draghi said last week, then it doesn’t matter that the Irish real economy is dormant.
As long as the Irish government sticks to the policy of turning the economy into a large debt servicing agency and the ECB gives it permission to do this by suggesting that Ireland will continue to “qualify” for support if necessary, then the bond market will stay open. But all the while the economy is actually getting weaker and weaker – not stronger and stronger, as you might deduce from a bond auction. Bizarre.
Just to mark your card for a scrap ahead, consider this: when Draghi said he would do “everything necessary to save the euro” last week, he signalled that he would take on the German lobby at the ECB because the only way he can save the euro is by buying Spanish and Italian debt directly. The Germans will, to use the vernacular, go ape. The Bundesbank has already issued a statement saying this is “problematic”.
Let’s come back to that titanic battle next week; we have enough to digest for now.