Monday 27 January 2020

Don't think 'It's all Greek to me' when it comes to crisis

The sooner we understand what the eurozone's troubles mean for us, the better, writes Paul McMahon

THE reason this type of global financial crisis is called a 'credit crunch' is because it does exactly what it says on the tin -- there is no credit available. Initially people may have believed this problem was confined to banks, but we are now seeing what happens when governments can no longer access credit.

Although related, we have moved beyond the debate concerning banks. Many western governments, like Ireland, have underwritten their banking sectors by one means or another. The new challenge is how to handle the threat of insolvency facing national governments.

A Greek rescue is being hastily organised, but we are left to wonder what countries could be next with Ireland, Portugal and Spain in the firing line in Europe, as worries are rising for Britain, Japan and even the US.

With so many other countries in trouble, rescue packages may not be possible for all. Not to mention that the real pain is only beginning for Greece, as it will struggle in the years ahead to repay this massive debt burden.

Governments have traditionally been able to carry heavy debt burdens and western governments are not usually subject to the kind of liquidity crises which plagued the banking sector where financial institutions are reluctant to lend to one another.

However, the appetite for risky government debt is waning fast and international markets will react harshly if governments take on too much.

All countries with large deficits and big debt-burdens are now threatened. Contrary to what some seem to believe, governments cannot just print money to fund spending, but must raise it in taxes, or borrow the difference.

We have enjoyed access to cheap European Central Bank funds during the crisis, but this support is coming to an end and we simply must be able to borrow in international markets, as we do not have the tax income to pay our way.

Investors are now clearly questioning if countries like Ireland have a sufficient tax-base to hold up spiralling government debt.

In the main, there are three simple government-related variables to examine: spending, income and debt burden. The question is at what point does the market believe the Irish tax-base (income) will be unable to support current public expenditure (spending) on top of the cost of carrying debt (burden).

This balancing act will ultimately determine whether Ireland can borrow from the international markets at interest rates that are sustainable. If the international markets do not believe that we have sufficient income to pay for spending and our debt burden, then we are the next Greece. At present we cannot raise enough tax to pay for current spending and, we have nowhere to hide as record-breaking deficits look set to continue.

This places the spotlight firmly on Ireland at a time when we do not wish to attract this kind of attention.

Because the amount of government debt is so much larger than our tax base, very small increases in the interest charged on our debt have greatly magnified effects on the portion of tax income required to cover this cost.

If international markets believe our Government is not getting to grips with the deficit problem, then interest demands will increase, as we have seen with Greece. Should Ireland have to face the 10 per cent interest cost demanded of Greece, then very quickly our (still-shrinking) current tax income would not be sufficient to support this additional requirement and access to funding would end.

The point is that because our debt burden is large, very small increases in the cost of borrowing have very magnified effects on the portion of tax revenue required to support it, potentially leaving Ireland facing default and rescue packages.

This would bring pain beyond what any of us are contemplating, but these risks are very real and imminent.

This crisis has precipitated such an enormous collapse in wealth that investors are now far more concerned with preserving existing wealth than accumulating further risks. For investors in government debt, fear is now a much greater motivator than greed. To put it simply, the herd is spooked and likely to stampede for an exit, at the first signs of trouble.

Sovereign default by one of the world's developed western governments should be averted by the Greek rescue package, but it will trigger a cycle of contagion across European debt markets.

Funding for governments who do not act quickly to cut deficits is evaporating, leaving countries like Ireland facing very grim options.

Having traded in the financial markets in Tokyo, during the aftermath of the Japanese crisis, I experienced first-hand the emotional and divisive debates between public and private sector, which wrenched Japan apart, effectively paralysing the political class.

During the Asian Crisis, I watched as entire economies collapsed en masse, and repeatedly saw these debates again rage and play out, across the continent.

The lessons are that crisis on this scale doesn't end with the flick of a switch, but is a process that is often drawn out.

History tells us that sovereign defaults are part of this process. Unfortunately we in Ireland now find ourselves in the firing line. But whilst squabbling amongst ourselves, perhaps we miss the point. The most dangerous threat we face is external, from the international markets.

There is a huge gap between the world of international finance and that of the general public.

Many very bright and well-educated people often have no idea about economics or international debt markets. Bridging that gulf is a challenge facing government, in order for it to bring the public with it.

Even very well-informed citizens tend not to realise just what a force the bond markets represent in the world. We have been hit by a crisis that will demonstrate in the starkest terms, whether we like it or not, that we are all in this together.

The bond markets do not respect public or private sectors -- it is Ireland that is now on trial.

The aftermath of this crisis is going to dominate the economics and politics of Irish society for at least a decade. It is important to try to understand it and to think about what's next.

Paul McMahon is a Finance, Strategy and Risk Consultant

Sunday Independent

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