Stephen Kinsella: Looking for a way out of this mess
In our hearts -- or maybe in that cavity where there should be a heart -- every economist is an accountant. We just don't have the personality to become accountants, I guess.
Accountants love balance sheets. It defines, at a point in time, the total value of your assets, the stuff you can use or get a benefit of some kind from, and the total value of your liabilities, basically your obligations to other people. These values have to balance. Hence the name.
Take a household, any household. Their assets might be the cash in their bank account, their pension, their car, their house. Their liabilities might be loans they owe to banks and IOUs of various kinds.
Forgetting about anything else that might be on a balance sheet for a moment, say you buy a house for €200,000. When you take out your mortgage, the value of the house goes in the 'asset' column, and the value of the loan goes in the 'liability column'. It all balances, 200,000 on each side, happy days.
But remember this is all about valuation. When the value of my home heads south quicker than a homesick starling, the balance sheet gets messed up. The asset side now says something like '100,000', but the liability side says '200,000'.
The difference between the two is negative equity, and a large part of the problem we're in at the moment derives from this balance sheet mismatch.
The discussion of debt in Ireland is one-sided -- literally, because it ignores the asset side of the balance sheet, choosing to focus on the liability side only. So, say I have my €200,000 loan, but I have the additional asset of a brilliant job with an income of €300,000 per year.
Despite my negative equity, I have no problem servicing the mortgage, and I can continue.
If my income is €30,000 per year, then things will not work out so well. The value of all of my assets is less than the value of all of my liabilities. I'm bust.
The damage to my personal balance sheet is going to spill over into at least one other balance sheet -- my bank's.
If I default, the bank must take a writedown on its balance sheet, and if the bank is covered by the Cowen-Lenihan blanket guarantee of their assets and liabilities, then the State's balance sheet is on the hook for any eventual losses in the private sector.
The connectedness inherent in the resolution of any imbalance is why we should be looking very carefully at the balance sheets of the major sectors in our economy.
Looking at the economy as a whole, we can see that liabilities increased enormously from 2002 to 2009 during the construction boom.
We were borrowing from the rest of the world to build houses to sell to one another. So household debt, for example, increased 300pc from 2002 to 2009. At the end of the boom, Irish people had borrowed over €210bn.
On the asset side, clearly the value of property has fallen precipitously, but the values of other assets like financial assets, pensions, shares, and so forth, have not fallen anywhere near as much.
Ireland's quarterly financial accounts show that the deep depression in terms of valuation is in the property sector and its related activities.
But the inflation and subsequent deflation of the property sector has damaged everything. Households, private firms, our banks, and even the State -- each interconnected balance sheet has been put fundamentally out of balance by this bubble.
To take just one example, the ratio of household debt to disposable income -- what you've got left over when all the major bills are paid -- is normally between 1 and 1.5 in developed countries.
At its height this ratio was over 2 in Ireland. This means that once all the bills were paid, for every euro spare, there were two euro owed.
When a household's assets are valued at less than its liabilities, consumption falls.
Consumer spending has fallen nearly 7pc since the peak in 2007, leading to more unemployment.Households have increased their savings rates, and paid down debt when they could. Balance sheets have also shrunk in absolute terms, as those who can afford to have moved assets somewhere else.
In the first quarter of 2012, the fall in assets and liabilities was over €20bn.
There are a couple of routes out of this mess. Either we reduce the debt levels on certain households, banks, and firms through insolvency procedures and NAMA-type operations, or we increase the incomes of those in unfortunate circumstances.
The second route comes when the economy grows. This means demand for goods and services increases, so employers hire more workers.
The single largest predictor of mortgage arrears is unemployment.
If we could reduce unemployment through a return to solid economic growth, then we would be in a much better position to heal our damaged balance sheets.
Until then, we must watch Ireland's balance sheets carefully.
Stephen Kinsella, PhD, is a Lecturer in Economics at the University of Limerick