Sunday 25 September 2016

EU stuck in deflationary trap with no escape plan

Ireland will struggle until the dysfunctional eurozone is turned into a proper monetary union

Published 16/03/2014 | 02:30

ECB HQ in Frankfurt.
ECB HQ in Frankfurt.
Economist Morgan Kelly

The inflating balloon of good feeling about the progress of the Irish economy has already stimulated happy talk about tax cuts and wage increases. The balloon took a couple of direct hits during the week, originating from what journalists would describe as "usually reliable sources". Both were domestic, to wit Professor Morgan Kelly of UCD's economics department and the Central Statistics Office. There were some developments internationally that worry me more than either Kelly's strictures or the CSO statistics.

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Morgan Kelly expressed concern about the risk to the small business sector from upcoming bank asset quality reviews and stress tests. In brief, many small firms, although viable (anyone still open for business after six years of purgatory must be doing something right), are owned by people up to their necks in debt.

The businesses may be OK but the proprietors are possibly bust, through borrowing for risky punts in the property market. Since some of this underwater borrowing may be secured on business assets, banks under pressure to clean up their SME loan books risk closing down viable businesses needlessly. Many small companies are managed best by the proprietor, and the proprietor cannot readily be dispensed with.

Professor Kelly is a little too worried about the SME loan book, not because it is in robust health but because it should be possible to handle it without doing too much collateral (no pun intended) damage. Nama, the government vehicle for taking underwater property loans off the books of bust banks, has re-installed the former proprietors of some property ventures as salaried managers, a practical solution in many cases and readily available if the banks have to move against non-performing SME proprietor loans.

Kelly appears to believe that the all-powerful and omniscient European Central Bank has crafted a cunning plan to use Ireland as a guinea pig in a road test of its masterful European banking strategy. In Friday's Irish Times he wrote: "The problem now is that the ECB is talking of doing a serious clean-up of the bad debts of Irish banks. Presumably this exercise is intended as a trial run to iron out the banks in economies that people care enough about for screw-ups to have real consequences." (I guess he means Italy, Spain, France and Germany).

In this, Morgan Kelly is attributing to the ECB a degree of coherence in its approach to banking policy of which there is no other available evidence. The real risk is not that the ECB will address decisively the ongoing European banking mess but that it will not be allowed by certain member states to address it properly at all.

The second balloon puncture of the week came from the Central Statistics Office, which revealed that real output (GDP) in the Irish economy actually fell last year. This was not meant to be part of the good news narrative.

Because of the large multinational sector, income produced in the Irish economy (GNP) is substantially less than output. The ability to service debt depends on income rather than output, so the GNP figure matters more. And GNP rose last year, so the figures were not bad news at all.


Government spokespersons have developed an addiction to the GDP (output) numbers, because they are larger and make the debt mountain look smaller relative to the GDP measure of activity. These little PR gimmicks come back to bite you from time to time. The multinational sector and its tax-shifting accounting policies make it hard for the CSO to keep the score accurately and the safest way to read the quarterly macro numbers is to focus on income (GNP).

The CSO release does not mean that the evidence of a bottoming-out and recovery in the Irish economy is misleading. There is genuine evidence of a recovery, patchy and not yet firmly established, but the beginnings of recovery nonetheless.

European finance ministers met again during the week and yet again failed to agree the key component of a banking union, namely the rules for winding up bust banks without bankrupting national treasuries. This is called the Single Resolution Mechanism and must be agreed by the commission, the eurozone finance ministers and the European parliament. The latter body will dissolve within a few weeks for new elections and it now looks unlikely that a bank resolution system which might actually work will be agreed anytime soon, if ever.

Meanwhile, the ECB has commenced work on an asset quality review for the 128 main banks in the eurozone. This will seek to identify inadequate loan loss provisions and the extra capital banks will need to make them unambiguously solvent again.

Since several eurozone countries have banks which look vulnerable as well as national treasuries which look empty, it is not credible to either announce that all the banks are fine and that none need any capital, or that some are bust but no mechanism is in place to deal with the problem. There have already been two sham reviews of eurozone banks by a body called the European Banking Authority which gave the thumbs up to banks that subsequently went bust.

The ECB's credibility as the new eurozone bank supervisor will be sacrificed on its first outing if it finds no problems at all in this new exercise, due to be completed by the autumn. But the politicians have failed to put a credible Single Resolution Mechanism in place, are running out of time to do so and may never have had the will in the first place. The risk of another failure to sort out the eurozone banking crisis rises with every week that is lost.

The ECB's governing council held its fortnightly meeting last Thursday and decided not to do anything for now about policy interest rates (already near zero) or about the eurozone's dangerously low inflation rate.

For countries which are heavily indebted, zero inflation makes adjustment very difficult. These countries see no erosion in the real burden of debt and nominal wages are hard to adjust downwards. It is easier to regain competitiveness if there is some inflation, even at a low level.

The eurozone inflation rate is meant to average two per cent. It has been below one per cent, and falling, in recent months. The indebted countries have inflation rates close to zero in many cases, Ireland included. If the eurozone's average was to be two per cent or so, which is supposed to be the target, it follows that the creditor countries would need to accept inflation at three per cent or even more, if the average target was to be hit. They are reluctant to do so.

A few weeks back, German Finance Minister Wolfgang Schauble took exception to the following remarks from European Economics Commissioner Olli Rehn: "A lengthy period of low inflation can make it more difficult if this low inflation is caused by core Europe inflation being very low.

"In order to succeed in the rebalancing process of the whole eurozone, average inflation should be close to the two per cent goal that the ECB has set," Mr Rehn said.

Schauble will resist, it would appear, any efforts by the ECB to get the eurozone inflation rate back up to the declared target.

The ECB should stop fretting about another cut in the policy interest rate, already almost zero, and start creating looser monetary conditions by purchasing directly securities issued by governments and business corporations.

Both the United States and the United Kingdom have been doing this for several years, but it would appear that ECB President Mario Draghi has yet to assemble a majority on the governing council to move in this direction.

The policy is called "quantitative easing" and has come to be seen (except in Germany) as the best available option when there are no shots left in the interest rate locker.

The real and present danger to the fledgling Irish recovery is not Morgan Kelly's reasonable worries about SMEs, or the CSO's disappointing output figures. It is the continuing failure to agree at eurozone level how to address two outstanding problems.

The first is how to get the European economy out of the deflationary trap to which it is still exposed, six years into the crisis, with bank balance sheets unrepaired.

The second is for the longer term: how to turn the dysfunctional common currency area into a proper monetary union.

Sunday Independent

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