Thursday 29 September 2016

Our economy is not fixed and if Europe goes belly up we are in real danger

Published 11/02/2016 | 02:30

Finance Minister Michael Noonan with Fine Gael candidates Anne Marie Dermody and Kate O'Connell Photo: Tony Gavin
Finance Minister Michael Noonan with Fine Gael candidates Anne Marie Dermody and Kate O'Connell Photo: Tony Gavin

Consider this scenario. A eurozone country that exited an international bailout a few years ago has an election. The result gives no clear mandate to any party or grouping to form a government. Weeks of discussions and jockeying take place. The president, whose role is largely ceremonial, becomes involved in trying to put an administration together. He is accused of being partisan.

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Finally, a coalition is cobbled together. But because it has disparate elements and a tiny parliamentary majority, it is weak and unstable. No sooner is it in power than a row breaks about with Brussels over its budget plans.

Then - from New York to Shanghai - international financial markets get the jitters. Suddenly, the country looks risky and investors rush for the exit. Government bond yields start to spike. Alarm bells begin to ring. Warning lights flash more urgently.

The prospect rises of the recovery being killed off. The risk grows that the still heavily indebted country will be tipped into a renewed bout of recession.

What is described above is not Ireland in a few months, but Portugal since last October when that country had a general election.

Our general election is 15 days away. Opinion polls point to many voters appearing to be unworried by the possibility of political instability causing economic instability, as is happening now in Portugal.

Yesterday's Red C/Paddy Power poll showed, as have all other polls in recent months, that the Fine Gael-Labour coalition will fall a long way short of a majority.

It also shows that no obvious combination of parties will be in a position to provide stable government. As a results, the odds on a second election later in the year are shortening.

The 'Sunday Independent'/Millward Brown poll of four days ago was particularly instructive. Its findings suggest that just one in 10 voters believes that managing the economy should be the top priority for the next government.

This could be interpreted as complacency among voters - many respondents seem to believe that the job of cleaning up after the crash is done and that the economy can run on auto-pilot.

Government by auto-pilot is possible. Solid democracies with independent institutions of state can get away with political instability in good times when their economies are sound. Belgium recently experienced a year and-a-half of caretaker government after inconclusive elections.

But Ireland's economy is far from sound and the outlook in Europe is getting cloudier by the day.

Despite the Irish economy growing very solidly, big weaknesses remain. Relative to their counterparts in Europe, Irish households, companies and the State are among the continent's most indebted. When the debts of all three sectors are added together, Ireland is among the most indebted countries on the planet. Going into any kind of a downturn with high debt levels is very dangerous.

And debt is not the only weakness. The banking system may be off life support, but it is a long way from full health. As of the middle of last year, a still massive one-fifth of the domestic banks' loans were non-performing, almost evenly split between mortgage arrears and companies being behind in their repayments.

While the share of dud loans is falling, it remains at one of the highest rates in Europe, and far above the 2-3pc levels that healthy banking systems experience.

Any return to recession would cause more people and corporates to have trouble servicing their debts. It would not take much for new concerns to arise about the adequacy of the banks' capital.

Ireland could probably get away with a period of political instability if the economies our exporters depend on continue to grow.

The good news is that Britain, the eurozone and the US are all growing. The (slightly) bad news is that there have been signs of slowdown in Germany and Britain in recent weeks.

The really bad news is that Europe's financial system is looking increasingly fragile.

Investors have been selling off bank shares across the continent. Although by no means a sign of impending doom (investors can panic like herds of wildebeest), once confidence in a banking system starts to erode, it can become unstoppable.

The weakest of the big links in the chain is the Italian banking system. It is in a dire state. That reflects the two-decade-long slump in the Italian economy, which is still the 10th-biggest in the world, despite its woes. Bad loans as a share of total loans in the Italian system are still lower than in Ireland, but unlike the situation here, the situation is deteriorating, not improving. Given that the Italian state is the most indebted in the eurozone after Greece, it has little by way of firepower to support its banking system.

In recent days, most focus has been on the biggest bank in Europe's biggest economy - Germany's Deutsche Bank. It has assets worth €1.6 trillion, making it one of the largest in the world by this measure. Its share price has fallen by 40pc since the start of the year (for comparison, it took Anglo Irish Bank's share price six months to fall by that much in 2007).

Much of the talk from financiers since the start of the year has been overblown in terms of its real economic effect - it very often happens that turmoil on financial markets ends up having little impact on the real economy.

But when a bad financial crisis hits, it can affect everyone. The collapse of Lehman Brothers in 2008 was one such case. Worryingly, there are whispers that the Deutsche Bank could turn out to be Europe's Lehman Brothers.

If the European economy suffers a return of the crisis that nearly tore the euro apart in the 2010-12 period, Ireland is in big trouble. Facing a return of such a crisis without a stable government would make matters much worse. Voters should at least consider these factors over the coming two weeks.

Irish Independent

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