Teaching Economics

This week I reviewed Meme Wars: The Creative Destruction of Neoclassical Economics (edited by Kalle Lasn and Adbusters) for the LSE Review of Books. (You can read the full review here). Meme Wars styles itself as an alternative ‘Econ 101′ textbook and the core of the book is a collection of short essays that question the ideas and teaching of mainstream, neoclassical economics. Its radical approach (in both design and content) might be off-putting to some, but I'd recommend it - both for experienced economists, as a challenge to think more broadly about underlying assumptions and fundamental questions about the purpose of the discipline - and especially for those who are new to economics, as an introduction to some alternative ways of thinking about the economy. 

While many of the criticisms raised here are already gaining traction within the discipline, for example through the emerging paradigms of ecological, behavioural and complexity economics, Meme Wars is right in complaining that these developments are generally not reflected in the economics taught to undergraduate students. A recent paper (available here) that tracks changes in the content of the bestselling introductory economics textbooks since the onset of the global financial crisis, would appear to confirm this view, i.e. little has changed.

However, that is not to say that 'mainstream' voices in economics are not willing to challenge the status quo. Meme Wars contains contributions from the likes of Joe Stiglitz and George Akerlof, among others. I also recently came across a collection of essays titled What's the Use of Economics? Teaching the Dismal Science After the Crisis edited by Diane Coyle (see here for details), which includes contributions from numerous established names in economics.

The currents of change and debate within economics make this an exciting time to be a part of the discipline. It would be a shame not to share this excitement with those being introduced to the subject for the first time.

Expert accountability

The ruling last week by an Italian court that seven scientists were guilty of manslaughter for failing to warn citizens about the threat of a major earthquake in the city of l'Aquila, raises some difficult questions about accountability and ethics in relation to the provision of 'expert' opinion and scientific advice to governments and the wider public. The scientific community and global media have reacted with outrage, comparing the verdict and threat of lengthy jail sentences for the scientists involved with the persecution of Galileo and the burning of witches.

I agree in principle and in spirit with this sense of outrage. The ruling appears to betray a lack of understanding of the inherent uncertainty in any scientific endeavour, which is particularly pronounced when it comes to forecasting future events. Furthermore, putting science on trial in this way threatens to curtail the progress of scientific inquiry generally, and more specifically--in the nearer term--to make the position of those charged with civil protection and disaster prevention, in Italy at least, almost untenable. However, there remains an important point relating to accountability and ethics that appears to have been overlooked amidst all the righteous indignation.

In an excellent article in Nature, Stephen S. Hall outlines the sequence of events that led up to the tragedy. In an extraordinary meeting of the National Commission for the Forecast and Prevention of Major Risks, the seven scientists--who were all members of the Commission--reached the conclusion that an earthquake was "unlikely" (if not impossible). This in turn was interpreted by a government official, speaking at a press conference, as meaning the situation in l'Aquila was "certainly normal" and posed "no danger". The same official further added that the sequence of minor quakes and tremors that had been occurring in the region was in fact "favourable ... because of the continuous discharge of energy".

This interpretation is apparently contrary to the scientific evidence. The same article, by Hall, quotes Thomas Jordan, director of the Southern California Earthquake Center at the University of Southern California in Los Angeles, and chair of the International Commission on Earthquake Forecasting (ICEF), as suggesting that in the aftermath of a medium-sized shock in a seismic swarm (a sequence of tremors), the risk of a major quake can increase anywhere from 100-fold to nearly 1,000-fold in the short term, although the overall probability of a major quake remains relatively low--at around 2%, according to a study of other earthquake-prone zones in Italy (G. Grandori et al. Bull. Seismol. Soc. Am. 78, 1538–1549; 1988), also quoted by Hall.

A 1,000- (or even 100-) fold increase in the probability of a major quake, would have been a very different message for public consumption than the "anaesthetizing" reassurances given to the media at the press conference. Clearly, the most egregious error committed here was in the over-, or indeed mis-interpretation, of the scientific evidence by the government official who spoke to the press. The scientists were--apparently--correct in their assessment that a major quake remained "unlikely", although not impossible. But, was this the best way of characterizing the risks for the general public?

One of the people affected by the L'Aquila earthquake, quoted in Hall's article, admits that he feels "betrayed by science"--"Either they didn't know certain things, which is a problem, or they didn't know how to communicate what they did know, which is also a problem."

It may be that the error here was not in mis-stating the risk, but in not being specific enough about it. There is an understandable reluctance to use statistics, probabilities and scientific terminology in the public communication of scientific evidence. But at times we take this too far. The public is not stupid, and--problems with common misunderstandings in relation to probability notwithstanding--would be better served by the scientific community and public officials avoiding condescending reassurance in favour of the clear presentation of facts.

Is woolly language, such as "unlikely" really any more useful or informative than saying simply "we don't know"? Might the committee have been better to present the available statistical evidence--including details about the changes in probabilities--while acknowledging that the precise timing and location of a major quake is essentially unpredictable?

The advice could have stopped short of ordering a full-scale evacuation--which, on the basis of the best available evidence, would have been unnecessary 98% of the time--and instead, simply presented that evidence, enabling people to make their own informed decisions about what level of risk they were willing to accept.

Returning to the issue of accountability and ethics, to what extent should scientific or other experts be held accountable for the advice they give to governments or to the wider public? In the case of the l'Aquila tragedy, a more relevant question might be; should researchers be held accountable for the way in which their findings are interpreted by policy-makers and, in turn, by the media? Should researchers generally consider how their findings are likely to be interpreted before making them public? This almost certainly places an unreasonable burden on researchers.

And yet--while researchers can't be expected to control how others interpret their findings, a greater effort needs to be made in communicating the science--its achievements and its limitations--directly to the public. With the recent proliferation of sources for news, opinion and analysis, the authority of traditional media outlets and the role of journalists and editors as the gatekeepers of public information, is increasingly being challenged. This presents both a challenge and an opportunity for scientific engagement with a wider audience. It is increasingly difficult for members of the public to distinguish the signal of scientific or expert analysis from (a) noise and (b) intentionally biased or deceitful opinion emanating from thinly disguised lobbyists, portraying themselves as independent 'experts'. On the other hand, the internet enables researchers to disseminate their findings, methods and data without intermediation by journalists or politicians.

The 'science on trial' headlines may sound melodramatic, but scientists from both the social and hard-sciences are right to feel they are being challenged to justify their art as at no other time in living memory. Public confidence in "science"--in its broadest sense--has been undermined by episodes such as the 'climategate' controversy. The discipline of economics, similarly, has been widely criticised for not predicting the financial crisis--and more fundamentally, for persisting with models that appear unable to explain 'real world' phenomena. This critique certainly has some merit, and economics as a discipline is evolving to take account of the lessons from related disciplines, notably psychology, biology and epidemiology. However, it has to be recognised--both by researchers and those who would criticise their efforts--that models, by their very nature, are imperfect simplifications of the world they are trying to explain. One clear responsibility of any researcher, is to think carefully about the domain of validity of the models that they use [PDF], to define their limitations, and to communicate this in an unambiguous and honest way, along with any findings from the research.

Reflecting on the trial of the seismologists, the former president of Italy's National Institute of Geophysics and Volcanology, concludes that "scientists have to shut up". On the contrary, the lesson for scientists from this tragedy and the subsequent trial, is to be more proactive in our engagement with the public.

A good starting point might be the establishment of a voluntary code of ethics for researchers. This would include, for example, a commitment to publish annually a list of all sources of funding for one's research. Furthermore, the code might also contain a commitment to make public not only our research findings but also the data and methodology used (including relevant context, limitations and assumptions). Signing up to this code could be a prerequisite for any government advisers, and could similarly become a useful tool for the media in screening 'expert' commentators.

More generally this code would be based on three fundamental guiding principles; honesty, transparency and humility. Going back to Hall's Nature article, he quotes a man who lost his wife and daughter in the earthquake, lamenting the fact that "the science, on this occasion, was dramatically superficial, and it betrayed the culture of prudence and good sense that our parents taught us on the basis of experience and of the wisdom of the previous generations." Perhaps the greatest lesson from this tragedy is the need for a greater degree of humility when it comes to the predictive powers of even the most sophisticated scientific models. 

A Year of Revolution

Update (2 January 2012): This article has been published in full on Irish Left Review and an edited (shorter) version has been published on Social Europe Journal. In a related piece in December's New York Review of Books, Michael Greenberg asks what future for the Occupy movement.

******

In a year of revolution, causes have been easier to identify than consequences.

In 1989, following the end of the Cold War, the American political scientist Francis Fukuyama wrote in The End of History? of the “unabashed victory of economic and political liberalism”, marking “the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government”.¹ In the decades since Fukuyama's landmark essay, the very concept of revolution – at least in the context of the rich, Western world – had itself come to be seen as an almost anachronistic idea. While still idealized in some quarters – most notably in student houses where posters of El Che [Guevara] are proudly hoisted to the walls, in defiance of the no-blue-tack clauses of student lease agreements – revolution had attained a quaint, nostalgia-tinged hue. That is, until this year. In 2011, revolution has returned to the center of global geo-political discourse. People have taken to the streets en masse across the Arab world, as part of the Arab Spring popular revolutions. The revolutionary fervour has since spread to the capital cities of the rich world. From Spain's indignados, to the riots in London, Athens and Rome, to the Occupy Wall St protests that have spread from New York to other major cities around the world, the Arab Spring is turning into a global Autumn of Discontent.

Viewed through Fukuyama's lens, the Arab Spring could be interpreted as the natural progression of these once repressive regimes into modern, Western-style democracies. How then do we reconcile with such a theory, the emergence of the Occupy movement, which originated at the heart of the financial-corporate-political nexus on Wall St? Certainly those involved in these protests, while apparently reluctant to articulate a list of “demands”, do not appear content to be living at the apogee of the modern participative democratic society.

There are many parallels in the genesis of these two movements (if the various riots, protests, occupations and revolutions are indeed reducible to two distinct groups according to their Western and Arab origins), and they appear to have fed off the oxygen of each other's success. The Occupy movement explicitly models itself on the Arab Spring's largely peaceful occupations of central squares and plazas. But the Arab world has also been paying close attention to the Western Autumn of Discontent. The London riots in August, for example, provoked jibes from the less “Western-friendly” Arab leaders about popular revolt and the London regime's hardline crackdown in response. The Arab media, more generally, appear to have been paying close attention to the Occupy movement long before Western media began taking the protesters seriously. The Tunisian blogger Lina Ben Mhenni has said she is proud of the role the Arab Spring has played in inspiring young people in other parts of the world to come out and “say 'no' to their systems”.²

The apparent solidarity between these groups of protesters should come as no surprise. In both cases the protests have been led mostly (although by no means exclusively) by young people. In a direct parallel of the Arab Spring, the Occupiers represent a generation increasingly disillusioned with a system in which many have been marginalized, without work or the prospect of a job, a system they claim has left them without a voice – thus the emphasis among protestors on the use of an elaborate and disciplined form of participative decision making. While national unemployment rates are running at between eight and ten percent in the US, Britain and the Eurozone (with double digit rates in Spain, Ireland and Greece), youth unemployment is significantly higher. In the US, 17% of under-25s are without work. In Europe, that figure is over 20%, while in Spain almost half (46.2%) of all young people are jobless.³

The Arab Spring was clearly a “liberal” movement, in the sense that popular protests rose up to challenge repressive, authoritarian regimes. But do its participants aspire to the particular version of liberalism that has been predominant in the Western world – and most particularly in the Anglo-Saxon world – over the past three decades?

Even during the boom times, when unemployment rates were relatively low, income inequality was rising in many rich countries – most notably those that pursued most vigorously the Anglo-Saxon model of deregulation (i.e. the US, Britain and Ireland). One of the most appealing slogans of the Occupy movement – “we are the 99%” – is a pointed reference to the top 1% of income earners, who in 2007 received 23.5% of total US national income, with an average wage income of around $713,000.⁴ Not since the late 1920s – in the years immediately preceding the Wall St crash and the Great Depression – the era of the “robber-barons”, have the few at the apex of the income pyramid, captured such a disproportionate share of national income.

The period since the beginning of the 1980s, which has seen the financial and economic elite steadily increase their share of national income, has been characterized by the political economist and former US secretary of labour Robert Reich, as the Great Regression. The systematic deconstruction of social and labour protections during this period has created a sense of financial and economic instability in young people's lives, the social costs of which have yet to be fully counted – but symptoms of which are evident in the recent violence on the streets of London and Rome.

Writing in 2007, in response to a UNICEF report at the time, which found British children had the most miserable upbringing in the developed world (with Americans second from bottom), Maria Hampton provided a remarkably prescient discussion of the causes and potential consequences of declining living standards for young people in the UK. Her article quotes LSE economist Nick Bosanquet and Blair Gibbs of the independent think tank Reform, who in their Class of 2005 survey characterised Britain’s under-35s – the “iPod Generation” – as insecure, pressured, over-taxed and debt-ridden.⁵ From among this generation have come the majority of the protestors.

So to consequences. In the Arab Spring, a mass popular movement coalesced around the clear and unambiguous goal of overthrowing brutal dictators. Now that aim has been achieved – in Tunisia, Egypt and Libya – the way forward is less clear. Similarly, the aims – and ultimate political consequences – of the Occupy movement remain unclear. From the outset, the Occupiers have been reluctant to specify their “demands”. While some in the media have seen this lack of focus as a reason to dismiss the protestors, for some within the movement, the process – with its egalitarian, democratic ideals and methods – is the cause. Avoiding setting out specific “demands” may also represent a clever strategy for the protestors, at least for the time being. As The Onion recently quipped, the public are waiting for the Occupiers to state their demands so that we can all rationalize our reasons for choosing to ignore them, and “go back to waiting for the sluggish economy to recover while blindly accepting things the way they are”.⁶

As the repeated failed attempts to solve the European debt crisis attest, simply muddling through and hoping for a return to the halcyon days of the mid-2000s, may no longer be a serious option. Lest we forget, there were mass protests in poor countries around the world, in response to high food and energy prices in 2008. Similar protests were seen recently on the streets of Israel. While the poorest may have felt the effects of the squeeze on resources before most, ultimately, these protests are symptoms of the same underlying problems. Indeed it was the rise in commodity prices – food and energy in particular – that pricked the bubble economy of the last decade. The unbalanced and unsustainable growth of recent years has left too many people, in both rich and poor countries, feeling disillusioned, marginalized and concerned about their economic futures.

There is now an urgent need to articulate an alternative to the failed neo-liberal agenda of recent decades. The financial crisis generally, and more specifically the recent protest movements around the globe, challenge us to consider what kind of society we wish to live in. If in every crisis lies opportunity, then we must embrace this opportunity to start a discussion about the ideals of liberty, equality and justice – upon which most modern democratic states were founded – and what these values mean in a modern, globalized society.

This crisis also presents a threat – one which will only grow in its potential to be destructive, if the underlying causes of the crisis are not addressed. The last time a financial crisis of this magnitude occurred, the world was plunged into a period of darkness. In the wake of the economic collapse, self-interested, nationalistic policies were enacted through the exploitation of people's fears and insecurities, culminating in the rise of fascism. The result was a global conflict that claimed millions of lives. We have already witnessed the rise of an “extremist” right-wing party in the US, with sufficient power to force the US government to the brink of default.⁷ Even the remotest sense of modern history should suffice to give us all pause for concern at such developments.

Writing in his last major publication before his death, the historian and social commentator Tony Judt warned that if the history of the 20^th Century has taught us anything, it should be a healthy suspicion of totalitarianism in all its forms.⁸ One such form has been the disturbing – and ultimately misplaced – certainty of the free market ideologues. Judt also argued that the great failure of the Left, in all its various shades, has been the apparent inability to articulate any coherent alternative to the predominant neo-liberal agenda of the past 30 years. Indeed, the ideological hubris implicit in Fukuyama's End of History could only have arisen in the context of an ideological vacuum to the Left of the predominant neo-liberal political-economic paradigm.

Back in 2007, Hampton concluded her article on the plight of British youth as follows: “If the crisscrossing fault-lines of greed, geopolitics and social inequality do reach a tipping point, we may well see a conflict between youthful brutality and the power of old age”. If we are to avoid such conflicts, we must start a conversation about the kind of society we want to live in and the state of the world we will pass on to our children. These are challenges for which there are no simple answers or quick-fix solutions. There will be dilemmas about how to balance competing aims that we wish to embrace. That does not mean we should not try.

- Dublin, October 2011.

1Fukuyama, Francis (1989). The End of History? The National Interest, Summer 1989.

2As quoted in the Irish Times Weekend Review, 22 October 2011.

3Rates quoted are from the Economist, 22 October 2011 (http://www.economist.com/node/21533447)

4Figures taken from Robert Reich's article “The Limping Middle Class”, NY Times, 4 September 2011.

5The article “Generation F*cked: How Britain is Eating its Young” first appeared in the magazine Adbusters (#71, May/June 2007) and was republished recently on the magazine's website, Adbusters.com (11 August 2011).

6“Nation waiting for protestors to clearly articulate demands before ignoring them”, The Onion, 12 October 2011.

7As characterized by Moses Naim in La Repubblica (11 September 2011).

8Judt, Tony (2010), Ill Fares the Land. Penguin.

Time to burst the austerity bubble

Meanwhile, Philip Lane is quoted in The Telegraph as saying "every [Irish] government for the next 20 years will have to keep cutting". As it is, we know the next two budgets will contain even more severe cuts than those being imposed right now. This is just what the government and "troika" have publicly admitted. What happens when the anticipated recovery (i.e. growth) doesn't materialize? More austerity?

It's time we all realized that the path we're on is unsustainable. Just as the boom was unsustainable - and on some level we all knew this, but allowed our instincts to be over-ridden by reassuring talk of "economic fundamentals" and "soft landings". The logic is simple and clear - this programme of austerity will not work. I think most people intuitively understand that. But we are allowing ourselves to be mollified by talk of restoring confidence, of "growing" exports and jobs. Just where are we going to export to, with the eurozone - and possibly the global economy - facing a sharp recession next year? Who is going to create jobs as domestic consumer demand continues to fall? The only thing we are growing right now is a generation of young people for export.

Stiglitz on the Euro Crisis

Joe Stiglitz discusses the sources of the present crisis and the (misguided) attempts to solve it, in this article. He includes several references to Ireland (direct and otherwise) ...

The prevailing view when the euro was established was that all that was required was fiscal discipline – no country’s fiscal deficit or public debt, relative to GDP, should be too large. But Ireland and Spain had budget surpluses and low debt before the crisis, which quickly turned into large deficits and high debt.

...

Without a common fiscal authority, the single market opened the way to tax competition – a race to the bottom to attract investment and boost output that could be freely sold throughout the EU.

Moreover, free labor mobility means that individuals can choose whether to pay their parents’ debts: young Irish can simply escape repaying the foolish bank-bailout obligations assumed by their government by leaving the country. Of course, migration is supposed to be good, as it reallocates labor to where its return is highest. But this kind of migration actually undermines productivity.

...

Public-sector cutbacks today do not solve the problem of yesterday’s profligacy; they simply push economies into deeper recessions. Europe’s leaders know this. They know that growth is needed. But, rather than deal with today’s problems and find a formula for growth, they prefer to deliver homilies about what some previous government should have done. This may be satisfying for the sermonizer, but it won’t solve Europe’s problems – and it won’t save the euro.

No Alternative to Budget Cuts?

It is often argued that there is simply "no alternative" to the destruction of social safety nets implicit in proposals to cut government expenditure, e.g. the Irish government's consideration of cuts to child benefit, a reduction in unemployment benefit and the introduction of medical card fees etc., as ways to achieve the required €3.8bn "adjustment" in the forthcoming budget. This line was repeated by Stephen Collins in Saturday's Irish Times. However, the idea that there is "no alternative" to a government decision could never be accurate. The "no alternatives" myth is nothing more than a politically convenient way of saying we don't want to consider the alternatives.

Thankfully, various groups outside of government have put together detailed proposals on alternative ways of saving money in the budget. Michael Taft of TASC has outlined potential "alternative" savings of around €6bn.

It's worth noting that some of the proposals here - e.g. removal of property tax reliefs - present the relatively rare opportunity for government, in imposing taxes, of a win-win on both equity and efficiency grounds. Removal of these reliefs would also represent a reversal of the much criticized policies of the previous government. Rather than subsidizing asset accumulation, taxing wealth (in the form of a property tax or capital gains tax) makes sense as both a progressive tax measure and one which avoids the disincentivization of work entailed in higher income taxes.

On income tax, the proposal to increase the top rate to 48% is still some way below the "optimum" top rate of tax (to be applied only to the top 1% of income earners) of over 70%, as calculated in this new paper in the Journal of Economic Perspectives, and discussed here (Paul Krugman's NYTblog) and here (Kevin Drum of Mother Jones).

The calculation is based on US data. For Ireland we might consider that the "behavioural elasticity", as Krugman calls it - i.e. the reduced work effort in response to higher taxes - is likely to be higher than for the US, given the historically high international mobility of Irish workers and the infamous culture of tax exiles among Ireland's elite. I'm not sure if studies on this elasticity exist for Ireland. But there is another way of looking at this. If we assume that the current top rate of income tax in Ireland is the optimum rate, what degree of "behavioural elasticity" would this imply? Ireland's top marginal rate of income tax is officially 41%. However, if we include the top rate of the Universal Social Charge (USC) at 7% and PRSI at 4% we have a top marginal rate of 52%. This implies a "behavioural elasticity" of about 0.62.* This is still higher than even the most conservative upper bound estimates for the US - around 0.57. Also, as Diamond and Saez note, most of the behavioural response observed in studies to date consists of tax evasion or avoidance behaviour, and not the kind of changes in real economic behaviour that opponents of higher income taxes claim to be concerned about (e.g. labour supply, business creation and savings decisions).

So while increases to the top rate of tax will be dismissed by this government on pragmatic grounds - that such increases would be self-defeating - such claims may not stand up to close scrutiny. Imposing a higher rate of tax on the top 1% of earners in society - and ensuring they actually pay their tax by closing loopholes, removing tax reliefs, and clamping down on tax exiles and tax evasion - could offer a more socially equitable and sustainable means of closing the gap between public revenue and expenditure.

Certainly the notion that we have "no alternative" to the proposed cuts, appears to have no basis in the available facts and figures. Instead it is revealing of an ideologically driven budgetary process.

*The calculation is based on the formula used in the paper by Diamond and Saez cited above: T = 1/(1 + ae), where T is the optimal top rate of tax, a is the Pareto parameter that describes the distribution of incomes at the top, and e is the behavioral elasticity. I assume that the distribution of incomes at the top in Ireland is roughly equivalent to that in the US and so I use the same Pareto parameter as used in the Diamond and Saez paper, i.e. 1.5.

The meaning of crisis

Crisis is a term rooted in Greek tragedy, meaning “a decisive moment or turning point in a dramatic action”. It is a moment of suffering and confusion, a time when everything that seemed to be fixed becomes suddenly unstable. The events of November 2010, with things spinning wildly out of control, certainly meet this definition. But the point of crisis in Greek tragedy is that it leads to catharsis, a sense of things being purged.

Václav Havel, then president of the Czech Republic and himself a distinguished dramatist, used precisely this metaphor while addressing his nation in 1997, when it had been hit by the twin scandals of political corruption and a banking bubble. “However unpleasant and stressful and even dangerous what we are going through may be, it can also be instructive and a force for good because it can call forth a catharsis, the intended outcome of ancient Greek tragedy. That means a feeling of profound purification and redemption. A feeling of newborn hope. A feeling of liberation.”

From that perspective, a cynic might be tempted to remark that the Irish are not even capable of having a proper crisis. We’ve had the unpleasant, painful and dangerous bit – and we’re going to go on having it for the foreseeable future. But we don’t do catharsis.

- Fintan O'Toole, Irish Times, 19 November 2011.

Deciphering the jargon of economic crisis

Frank McNally provides a guide to the crisis jargon in Saturday's Irish Times (19 November 2011). Two definitions that stand out:

Quantitive Easing: The process whereby the number of economists appearing on Irish TV shows is increased indefinitely, in the hope that the country can talk its way out of the crisis, even at the risk of rampant ego-inflation.

Standard & Poor: Adjectives describing the two main types of judgment exercised by ratings agencies when assessing the sub-prime mortgage packages that started the whole mess in the first place.

Learning our Lessons

Letter to the Irish Times, 5 December 2010 (not published)

A chara,

Stephen Collins makes the now standard error of blaming wide swathes of Irish society for our current woes ("Bailout teaches what we should have learned years ago", 4 December). We will be living with the consequences of decisions taken by a reckless minority in this country for many years to come. However, we should be very clear about one thing: this bailout and the concomitant loss of sovereignty, has been precipitated by the actions of private banks - both Irish and others - actions which our present government and it's European 'partners' now expect Irish people to take responsibility for.

Is mise,
Tom McDermott

Breaking down the "bailout"

Phoenix magazine had a very clear breakdown of the "bailout" in its most recent issue. (I couldn't find it online - you need a subscription - so I'll just quote some of the key points here)

Total borrowing involved in bailout: 60.5bn euro (the remainder comes from Ireland's own funds - pension reserve and whatever cash the NTMA has stored up).

Of this:

- 22.5bn is from IMF at interest rates of around 3-4%

- 17.5bn from the European Financial Stability Facility

- 22.5bn from the European Financial Stability Mechanism

EFSF is mainly German and French money. It's a special vehicle set up to fund EU members in need of restructuring funds. It operates in conjunction with the German Debt Management Office.

According to the framework agreement which set up the EFSF, the interest rate to be charged is "intended to cover the cost of funding incurred by EFSF and shall include a margin [ie a profit] which shall provide remuneration for the guarantors". On top of this there is a service fee to cover operational costs and various fees, which is charged upfront at 0.5% of the total loan (ie 88m).

The rate applied is based on "the rates corresponding to swap rates for the relevant maturities" (today approx 2.7%) plus "a charge of three percent for maturities up to three years and an extrra one percent per year for loans longer than three years" (ie 6.7% - making a profit for the EFSF of 4bn over the lifetime of the, ahem, "bailout"!!!).

It gets worse.

"The anticipated margin that would accrue on each loan to its scheduled maturity date shall be deducted from the cash amount to be remitted to the borrower in respect of loan. The service fee and the net present value of the anticipated margin ... will be deducted from the cash amount remitted to the borrower in respect of each loan but shall not reduce the principal amount of such loan that the borrower is liable to repay and on which interest accrues under the relevant loan". [that quote also comes from the framework agreement].

(ie they take their 4bn of the 17.5bn they are lending us before the money ever gets to Dublin, while charging interest on the full amount!).

EFSM money will be charged at 5.7%, if we draw down the full amount. (Greece paid 5.2%).

Ireland's so-called "bailout"

What's happening now is a variation on what I complained about previously (in my unpublished letter to the Irish Times, posted here). Rather than using the "we all partied" line (and what a gem that is -

http://www.youtube.com/watch?v=YK7w6fXoYxo) the line now is this crap about the state running out of money, having no alternative etc., with Fianna Fail taking some culpability for some mistakes somewhere in the distant past (but sure the others would've done the same anyway), and ultimately we should be grateful to our Euro "partners" for bailing us out of this fine mess we've gotten ourselves into.

This is all a web of lies, deception etc. The only reason markets stopped lending to Ireland in the last few weeks is because of the bank debt that has been nationalised. WE CANT AFFORD TO REPAY THIS. The markets know this. Our banks have been shut out of international markets - because their losses on property etc. have been rising beyond any "worst case scenarios" previously envisaged, and because they had become entirely reliant on money from the ECB (this is its role remember: CB = lender of last resort to the financial system, so let's not feel too grateful/ashamed for requiring this facility either). Then the markets got really spooked when Merkel started talking about making bondholders share the pain without giving any details.

So Ireland was pressured into taking the bailout in an attempt to "stuff" the banks with cash (over-capitalise them is what Gov Honohan called it) and convince markets this was the end of it so they would start lending to our banks again. The whole point was to avoid "contagion" to the other Euro countries in trouble. This hasn't worked. Big surprise. The bit about using this money to fund the Irish state is a total sideshow.

We do need to make a big "fiscal correction" over the next few years, but that is totally doable.

So, yes I believe we do have an alternative. As David McWilliams has been saying, what we need is a new "bank resolution" law (I don't think any such legislation currently exists in Ireland, so creating an entirely new one should be straightforward). The law would simply state that in Ireland, when a bank becomes insolvent (the Irish CB could be allowed to decide when this is so) that bank's bondholders must share the burden. Specifically we would create a debt-equity swap mechanism. Bondholders who are owed money by an insolvent bank will have their debt converted into equity (or shares in the bank). The bank doesn't disappear. In fact the bank is now significantly healthier as it has rid itself of debt. Depositors would have to be protected by some sort of insurance. (The Irish government already guarantees anything up to EUR100k. I'm not sure if we would need European cooperation to guarantee bigger deposits.)

The bit about all the medium sized firms imploding in such a scenario is probably exaggerated. Our banking system wouldn't disappear over night. As it is, small firms are having a really hard time getting credit because whatever money goes into the banks is being used to pay down their debts and/or build up these extra capital requirements that are supposed to make them look like good banks again.

So the banks' bondholders would suffer losses. But they expect this, because it will become European law in 2013. Anyway, even if we piss off some investors, so what?! Would the markets ever lend to Ireland again? Of course they would. The 'markets' are not a single entity with some sort of institutional memory. They are made up of lots of different investors all over the world. Investors do not generally hold grudges. They make decisions based on future prospects of risk/return. Even if some of the specific individuals that get burned in this scenario did decide to take it personally and never lend to Ireland again it wouldn't matter. Ireland is small. So are our funding needs by international standards. There are plenty of more investor fish in the sea, so to speak.

An Irish state that is rid of its bank debt obligations would represent a very attractive investment (especially at the kind of rates we are paying for this so-called "bailout"). We will still have low taxes by European standards (even after we get our fiscal house in order). We have a young, well educated workforce. We have a hugely successful manufacturing and internationally-traded services sector, with highly profitable divisions of some of the world's biggest companies based here. We have a lot going for us. Yes this course of action involves some reputational damage, but would that really be worse than the reputational damage already done by fiscal and economic mis-management? And the reputational damage of having to be "bailed out"?? Distinguishing between the Irish state and the Irish banks might actually be a good way to begin restoring our damaged reputation overseas. Anyway, a damaged reputation (and some bruised egos) is a lower price to pay than the costs associated with this bailout and our continued commitment to pay for whatever losses are accrued by our reckless banks.

The only economist who got it right...

... Marx of course! (see Deaglan de Breadun's article in the Irish Times).

Forever blowing bubbles

Hyman Minsky's model of the credit cycle includes five stages: displacement, boom, euphoria, profit-taking, and panic. See this article "The Minsky Moment" from the New Yorker (February 4, 2008).

Paul Krugman has also written a nice piece, entitled "The Ice Age Cometh" on the evolutionary psychology behind irrational asset price bubbles.