February 11, 2013
Let’s be clear about what happened last Thursday and the implications of the deal. In the short run, it’s positive, but maybe not so later on.
For the record, let me put my hands up and say I never expected the ECB to acquiesce to such extended maturities, which are very positive for the cashflow of the country over the next few years. So, in terms of cashflow management, this was an excellent move. I very much underestimated how much the EU would move on this.
We have negotiated what is called in finance a ‘balloon payment’. There are no payments, bar interest, for the first while, and then all the payments are due in a balloon payment at the end. This is when the once-sick country has left intensive care, has recovered and is strong again.
This type of arrangement should actually be called life-support financing. It is not that rare. When a bankrupt company is being kept alive, it is normally for the benefit of creditors who refinance and accept something back tomorrow, rather than nothing today.
The odd thing about the deal is that Ireland was both debtor and creditor. Therefore, we kept ourselves alive to prove to others, such as the ECB, that we are indeed alive. We are stretching out payment to ourselves from ourselves.
We are celebrating a deal with ourselves, and will pay ourselves from our own pockets to prove to others – who are neither creditors nor debtors in this deal – that we are still alive. It’s like being put on life support where the drip goes from one arm to the other. Unusual, don’t you think?
Let’s gain a bit of altitude above the din of backslapping to see what is happening. The article will be split three ways. First, what exactly happened and why? Secondly, what does it mean right now? And thirdly, what might it mean in the years ahead if growth is lower than is considered normal?
Usually, when a company is liquidated, the assets and the liabilities are added up. If the liabilities are greater than the assets, the company doesn’t try to borrow from someone else to pay the difference. It folds. The assets are sold and the money is divvied up among all the creditors. That’s it.
The spoils are governed by well-understood corporate finance rules where there is a hierarchy of most-deserving creditors. In the case of a bank, depositors might be termed ‘trust creditors’ or ‘creditors in trust’ because they trusted the institution and the system. They could get ‘special’ status and get first dibs on the money. Thereafter, various other creditors get paid out of what’s left.
In the case of the Anglo deal the other day, all creditors get paid, irrespective of the fact that the assets amount to a fraction of the debts. But in this case, the creditor and debtor were one and same outfit, the Irish state.
The Irish Central Bank was the main creditor. It gave money to Anglo and was promised the money back from the state under the promissory note. Had the government not repaid the promissory note, the Central Bank would have had a large loss on its balance sheet.
Would that have mattered to anyone? Actually, no. It would have been lodged as negative Central Bank capital on the asset side of the balance sheet, and there it would stay. The money printed was used to pay Anglo’s bondholders and that was where the story would have ended. This is what a normal central bank would have done. It is the same when a central bank extends money against a security and that security falls in value – the central bank has a dodgy asset on its balance sheet. But who cares?
The ECB cares because the ECB is dominated by the German view of money. This contrasts with other perceptions of what money is. For many, me included, money is a ‘tool’ to be used to move the economy onto a different growth path, to be used to solve problems and to be used to get the real economy – the production and sale of goods and services – going. It is a tool to be used by our Central Bank.
To the Germans, money is not a tool but a ‘public good’, a bit like fresh air or the environment. It must be preserved and protected by laws and rules, which are unbreakable. It can’t be used as a tool to move the economy or to rescue the economy from a slump. This is a deep philosophical difference between the Germans and others.
It is not surprising the Germans think this way. After all, this is a population that suffered hyperinflation and was brought to catastrophe by a man who regarded treaties and laws as little more than pieces of paper. We hear that they are scarred by hyperinflation which, according to the narrative, led to the rise of Hitler.
But frankly, that’s their history, not ours. Yet Irish people are hostage to the monetary consequences of German history, rather than the economic prerogative of the Irish present. It seems hard to understand why the population of one country should be hostage to the historical echo of another country’s experiences.
This unusual Germanic export explains the strangeness of Ireland taking a year to negotiate a deal, stretching out payments to herself, from herself. This is why the ECB is only telling half-truths when it says it ‘took note’. It took note and our lads ‘took fright’.
Now, the short term. In the years ahead, the deal will improve our national cashflow in the same way as financing a kitchen extension or a car on an interest-only loan would improve your weekly cashflow. You hope that your house will rise in value in the meantime, made more attractive by the kitchen, and you hope that there will be no calls on other loans that you might have taken out. After all, you elected to go for ‘interest only’, not just to improve your cashflow, but in order to let you borrow more.
More borrowing is what ‘getting back into the market’ means in plain English.
So Ireland hopes that, over the next few years, there will be no more euro bond/credit problems because we have loaded more debt on ourselves. If there is another shock to the system, the high-yield risky countries with lots of debts – like Ireland, Spain or Italy – will suffer speculative attack, default will threaten, money will flow out and yields will rise. As night follows day, another crisis will occur.
Now, let’s briefly look at the long-term wisdom of debt build up when interest rates are low. We assume that, if we take on debt now, we will be able to pay it and, when the economy settles, it will return to around a 3 per cent annual growth rate. Many regard 3 per cent as being ‘normal’. But what if the new ‘normal’ is 1 per cent, not 3 per cent?
Growth rates are based on labour force growth and productivity growth. According to Forfás, “labour force growth will continue to make a contribution to overall economic growth over the period to 2020, but thereafter there will be a higher reliance on productivity growth”. So where will the productivity come from?
Normally, productivity comes from manufacturing. Productivity in services tends to be lower. Compare a factory worker with lots of machines to a barman. But, in Ireland, manufacturing is shrinking as services are rising.
Services already account for 72 per cent of the economy. This is stuff we tend to trade with ourselves. I buy small stuff from you and you buy small stuff from me. Last year, services accounted for 44 per cent of total exports from Ireland. By 2025, the ESRI projects that “market services will account for 60 per cent of value-added in the Irish economy and in excess of 70 per cent of all Irish exports”.
So, as the economy moves to more services and less manufacturing, productivity will fall, not rise. Another thing which will drag down growth will be the cost of energy. Ireland is now the most oil-dependent economy in the EU and one of the countries most dependent on fossil fuels for electricity generation. Fossil fuel availability will continue to diminish in the future and its cost will rise, dragging down growth.
If the new normal growth rate is not 3 per cent but 1 per cent, and the average rate of interest over the terms of all these loans is 3 per cent, not 1 per cent, what then?
I could be wrong. I was wrong on the maturities of the deal. We might stumble on a productivity miracle. We may have a transformative oil find off the coast. We may receive a million clever immigrants from somewhere, but it’s worth seeing last week’s events in their totality before cracking open the Gewürztraminer.
David McWilliams’ new book The Good Room is out now.