Transcript Macro Exam Summer 2005

Irish Economy 2009
Solutions
Question 1a
• In an open economy with free capital flows, under
what conditions is it possible for domestic and
world interest rates to diverge?
• Basic answer: Uncovered Interest Rate parity.
– Interest rates may deviate if the exchange rate is
expected to appreciate or depreciate.
The capital account CP
To understand the flow of cash to buy and sell
assets, consider an investor contemplating
buying a one-year bond:
Should she invest at home or abroad?
Invest at home – at end of year
€1 becomes €(1+i)
Invest abroad -
1  1/ E  (1i w )1/ E  (1i w ) Ee / E
where
e
E

is the expected exchange rate at end of year
Uncovered interest parity (UIP)
Requires that the expected return from investing
at home is the same as the expected return
from investing abroad, so
1  i  (1i ) E / E
w
e

aproximately equals
i 
iw
 ( Ee  E ) / E
that is, domestic interest rates equal world interest rates
± the expected rate of depreciation (apprecation)
Question 1b
• Under floating exchange rates the balance of payments will balance in
the sense that the sum of the current account and cap account will be
zero: Curr +cap=0
• So if there is a current account deficit there must be a cap account
surplus (inflow)
• This must be the case because there is a free market in currency so
flows. So if curr+cap <0 for an instant there would be excess demand
for foreign currency ($) and excess supply of domestic currency (€)
• Basic micro theory tells us that the price of $ must rise in response to
the excess demand i.e. the domestic currency depreciates.
• This depreciation will make the country a more attractive investment
(cap inflows increase) and boost next exports (current account
improvement).
• If the e rate is truly freely floating it will adjust fully and
immediately to close the deficit or surplus in this manner.
Obviously in the short run most of the adjustment will take
place through the capital account.
• If the e rate is not free floating then the whole of the deficit or
surplus may not be cleared. In the extreme case of a fixed rate,
the deficit will remain. The continuing excess demand for $
will be met by the central bank supplying $ from its reserves
• So for fixed or floating e we can say that the BOP balances in
the sense that the following is always true: cap + cur – change
reserve = o
• In the case of floating e the change in reserves is identically
zero
• Sometimes the change in reserves (or “official financing”) is
considered as part of the capital account.
Question 1c
•
•
Comment on how the balance of payments
reflected the boom and property market
bubble in Ireland during 2002-7.
Basic answer is that a boom in the
domestic property market shifted the AD
curve to the right. This lead to an increase
in wages and price reducing
competitiveness and net exports
LRAS
P
SRAS(Pe=PA)
SRAS(Pe=Pc)
C
B
A
AD1
AD0
Y*
Y
Prices (Competitiveness)
•
Real Exchange Rate
– Compare price levels of different
countries
– Simple example is the Hamburger
index
•
Do for all goods in a basket and
calculate the ratio
– i.e. CPI or GDP or wages
Look at R for Ireland over time
– Level doesn’t tell much
– Trend does: we get expensive
– Trade weighted real e rate rises by
about 30% from 2000, having
fallen by 20% the previous decade
$PIRL e * PIRL
R

$PUS
PUS
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
20
08
20
06
20
04
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
19
78
19
76
19
74
19
72
19
70
Competitiveness
250.000
200.000
150.000
NEER
REER
100.000
50.000
0.000
Crowding Out
• The consequence of the housing boom was the
misallocation of resources i.e. crowd out other
aspects of the economy
• Exports
– Boom forces up prices and competitiveness suffers
– Don’t notice during boom (because I is high)
– Notice now!
• A caveat
– Balassa-Samuelson theory
– Expect richer countries to be more expensive
– Nevertheless, Ireland became more expensive
than countries of a similar level of wealth.
– See graphs
2000
2004
Cap flows
• Extra credit for this
• International Credit conditions fuelled the
bubble in some countries
• Ireland
– Huge capital inflows to Ireland
– Cap a/c surplus reflects insufficient savings
– Banks foreign borrowing
• On the way up this financed the boom
National Savings
• Two identities
– Y=C+I+G+NX
– Y=C+S+T
• This imply
– S+(T-G)+NX=I
• So insufficient domestic savings were
supplemented by capital inflows
• Boom financed by cap inflows via banks
Savings
35.00%
30.00%
Personal
25.00%
Corporate
Gov
20.00%
Inv
CA
15.00%
10.00%
5.00%
0.00%
1995
-5.00%
-10.00%
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Question 2
• These are short questions so students don’t
have time to give the full answer as outlined
below
• So be generous!
2a Discretionary FP
• Changes in the AS/AD curves cause actual
real GNP to swing around natural real
GNP.
• Keynesians advocate an active fiscal policy
(changes in government expenditure and/or
taxes) to try to stabilise the business cycle.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
The Stance of Fiscal Policy
A recession automatically worsens the budget deficit. Tax
revenues fall and social welfare spending rises.
• Diagram shows how the budget balance varies as GNP
changes.
• Boom period, the deficit falls.
• Positive relationship between Net Taxes and GNP.
•
Current spending (G) is assumed to be constant.
• Note distinction between automatic and discretionary
changes in the budget balance. Discretionary change
occurs when the government deliberately changes G, T or
SW.
•
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Full-employment budget
G, NT
Natural GNP
NT
€ billions
Budget surplus
B
A
Government
expenditure (G)
C
Budget deficit
GNP
Balanced budget
1
GNP *
GNP
2
Nominal GNP
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Discretionary changes in taxes and expenditure
NT2
Natural GNP
G, NT
NT
1
NT
3
€ billions
B
GNP 1
A
C
GNP *
GNP 2
Government
expenditure (G)
Nominal GNP
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
2b: Laffer Curve
• Changes in taxes can give unpredictable
results. Refer to the Laffer curve.
• Examine relationship between tax rate and tax
revenue.
• Optimal tax rate: T*
• Below optimal: normal positive relationship.
• Above optimal: an increase in tax rate may lead to
a decrease in tax revenue. High taxes affect the
“incentive to work” and drive industry into the
black economy, as we saw in Ireland in the mid1980’s.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Laffer Curve
Average
tax rate
100%
A
T1
Z
T*
T2
Revenue
maximizing
tax rate
B
0%
R1
R
2
Tax revenue £m
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Problem with Laffer Curve
• Not clear where the revenue max tax rate is
– Peak of curve
• Is it above or below current rates?
• Highly ideological debate
• Current government policy implies they think we
are at max as they didn’t raise or reduce taxes in
budget
• Is this likely? Do they have any evidence for this?
2c: Growth in Celtic Tiger
Convergence due to
1. Rapid rise in ratio of non-agricultural
employment to population
•
–
This in turn due
Demographic factors
•
–
Decline in proportion aged under 15
Exceptional growth in numbers at work outside
agriculture
2. Reasonable growth in productivity
•
•
High by some standards
But no miracle
Demographics
The fall in birth rate after 1980 could be
regarded as
– Ireland’s belated convergence to the
demographic norm for a developed country
• Facilitated by rising female educational levels
and
• Changes in attitudes and laws concerning
contraception
• Triggered by rise in unemployment in early
1980s?
Where did the economic growth come from
in the 1990s?
38%
62%
Productivity
Employment growth
2d: PPP
• PPP: equal value for money for goods and
services.
– Prices of similar goods expressed in a common
currency should be the same.
– Based on arbitrage. Buy cheap, sell expensive
to make profit.
– Actions should lead to a convergence of prices
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Absolute PPP
• Pirl  e = Pw
• Prices, adjusted for the exchange rate,
should be the same in different countries.
• Example: Levi Jeans,
• Pirl = €10 in Dublin,
• Pus = $20 in New York.
• If e = $/€ = 2 then PPP holds.
• If e  2, PPP does not hold.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Real Exchange Rate
• Compare price levels of different countries
– In a common currency (usually US$)
• Related to the concept of purchasing power
parity (PPP)
– Law of one price
• Simple example is the Hamburger index
– What is the US$ price of a Big Mac in various
countries
– $PIRL=€ PIRL*e
– Is $PIRL >$PUS
• What does this tell you?
– “competitiveness”
– Are one country’s goods cheaper than
another’s?
• Do for all goods in a basket and calculate
the ratio
– i.e. CPI or GDP or wages
$PIRL e * PIRL
R

$PUS
PUS
• Look at R for Ireland over time
– Level doesn’t tell much
– Trend does
Relative PPP
• Total differentiation of the absolute PPP equation
gives:
•  Pirl +  e =  Pw
• Or irl + e = w
• Inflation rates, adjusted for changes in the
exchange rate, should be similar across countries.
• Weak form of PPP.
– Prices can be initially different, but change at the same
rate over time.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
PPP as a Economic Theory: Under
Flexible Exchange Rates
• PPP becomes a theory of exchange rates.
•  e = w - irl
• Inflation is the most important determinant of e.
Country’s with high inflation rates will experience
weak exchange rates and visa versa.
– Why?
• Very relevant in the case of large countries: USA,
Japan and EMU.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
PPP as an Economic Theory: Under
Fixed Exchange Rates
•
•
•
•
PPP becomes a theory of inflation.
irl = w -  e
If e is fixed, irl is determined by w.
Ireland is a price taker on international
markets.
• One of the main reasons for fixed e
– EMS & EMU.
• Used by small countries world-wide.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Q3: Irish vs US FP
• Basic answer
– The US government is applying standard
Keynesian demand management to the current
crisis.
– The Irish government is doing the opposite
because it believes that the debt is already too
high and any further increase will reduce
confidence and hence AD
• Figure 1 shows what the US government is
doing i.e. applying an increase in aggregate
demand to a demand shock.
•
Start from LR eqm
–
–
•
Y=Y*
Pe=P
The fall in AD
–
–
•
•
Eqm moves from A to B
Y<Y*
Recession
We could wait for the economy to adjust automatically
to C
•
•
Prolonged recession
Alternatively we can increase aggregate demand by
increasing G and/or decreasing Taxes
–
–
This will shift AD curve to right and economy will move from
B to A
This is US policy
Policy for a AD shock
LRAS

SRAS(Pe=PA)
SRAS(Pe=PC)
A
B
C
AD0
AD1
Y*
Y
Differences between US and Ireland
• Or between any large country and a small open
economy
• US issues debt in its own currency
– Can use inflation if necessary
• Possibility of a dynamically unstable debt in ireland
– Borrowing to pay interest
– Burden of €35,000 per worker already
• FP policy likely more effective (see later)
• US can depreciate its currency
– Could expand economy by depreciation
– Control deficit by cutting G, raising T
• US can reduce interest rates
What is to be done?
• For any SOE conflict between two basic issues
– Stabilisation policy
– Deficit control
– Empirical question
• Stabilization policy
– Ideally we would want to increase the deficit in a recession
– Shift AD to right and restore full employment
– Some of deficit is the automatic stabiliser but could do
more
– Blanchflower argued this recently
• Deficit control
– Irish deficit this year heading towards €30bn = 13%GDP
– 13% not sustainable forever
The Multiplier
• A key detail ails of stabilization policy are key
– What is the multiplier?
– The effect of any G on Y
– Theory suggests low in SOE
• Reason: any increase in G will lead to an
increase in imports so that the stimulus will be
lost to the Irish economy
Negative Multiplier
• Expansionary Fiscal Contraction
– Multiplier negative in times of crisis
– Failure to deal with debt causes people to cut back
consumption
– AD shift to left
– Very controversial idea
– Some evidence for it including Ireland in 1987
• Small multiplier argues against traditional
stabilization policy
– If Neg mult no conflict between the two goals
Deficit Control
• If the multiplier is positive cutting deficit now
will make recession worse
– If mult is negative there is no conflict
• So why do it now as distinct from postponing
to the future?
• Dynamically unstable debt
– 13% of GDP is unsustainable
– End up borrowing to pay interest
– Lenders might refuse loan
• If we decide to control deficit there are two questions
– How much how soon?
– By taxes or expenditure?
• Time
– Do not have to close all the gap immediately
– Governments plan is to bring within 3% of GDP within 4
years
– That is actually quite quickly
• Automatic stabiliser will close some as the economy
improves
– So plan should concentrate on the structural deficit
Tax or Expenditure
• The Big question today is whether we choose to close
the gap by increasing taxes or cutting expenditure or
in what combination
• All these actions have multipliers
– Probably all positive (assuming no EFC)
– Some bigger than others
– Lane suggests inv > wages
• Government seems to favour expenditure cuts. Why?
– Philosophy: ideology supplants evidence
– Multipliers: unlikely
– Laffer Curve
International Evidence
• Empirical matter whether tax based or exp
based budget is better
• Policy makers remember Ireland’s experience
of 1980s and 1990s
– But that is just one observation
• There is a large literature looking at deficit
control worldwide
– Conclusion is that expenditure based more likely
succeed
– Evidence is not overwhelming
Q4 Celtic Tiger
• Note that the student is free to talk about
any 5 (or more) of the policies outlined
below
• If they don’t show how these policies affect
the AS-AD (last slide) then award no more
than 60%
Economic Policy in the Tiger
•
•
•
•
•
•
•
•
•
•
•
Distinguish between pre-boom factors:
1. Foreign direct investment (Industrial policy).
2. External assistance.
3. Investment in education.
Factors that combined to ignite the boom:
4. Centralised wage bargaining.
5. Fiscal policy.
6. Upturn in World (US) economy.
7. Achieving EMU entry criteria.
8. Exchange rate policy.
9. Small is beautiful.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
1. Industrial Policy
•
Success of IDA in attracting high-tech foreign
multinational companies (MNCs): microelectronics,
pharmaceuticals, medical instrumentation, computer
software, financial services, telemarketing.
• However, the contribution of MNC’s can easily be
exaggerated.
• Need to take into account their high level of imports
(including payments for patents and royalties) and
repatriated profits.
• Contribution to GNP in 1998 was only €4.8 billion.
Considerably less than the sales figure.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
2. External Assistance
•
•
•
•
•
1973-2001:
Total net receipts = €33,853.5 million.
Annual average of €1,167.4 million or 3.9 % of GNP.
The peak was 6.6% of GNP in 1991.
Paid under a variety of headings: agriculture, social,
regional and cohesion funds.
• Money mostly spent on roads, railways,
telecommunications.
• Greatly improved the country’s productive capacity.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
3. Investment in Education
• The importance of “human capital formation” in the
growth process.
• 2000:
Primary
€1,068 m
Secondary
€1,243 m
Third level
€838 m
• Well educated labour force acts as a magnet to foreign
multinationals.
• Much of this investment took place in the 1970s and
early 1980s.
• Note: Factors 1 to 3 were in place in the 1980s and do
not explain the spurt in growth in the 1990s.
Considered to be essential pre-conditions.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
4. Wage Bargaining
• Wage moderation following a return to centralised wage
bargaining.
• National wage agreements involving the trade unions,
employers and government.
• In return for moderate increases in nominal wages, the
government promised tax cuts at budget time.
• For a number of years, inflation was greater than the basic
wage awards resulting in a fall in real earnings.
• Improved Ireland’s competitive advantage.
• Only applies to workforce of 500,000 out of total
employment of 1.7 million.
• May or may not have facilitated the IDA’s industrial
policy.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
5. Fiscal Policy
• Restoring oder to the public finances in late 1980s was a pre-condition
for a resumption of economic growth.
• Improved investor confidence and reduced the outflow of capital.
• Tax rates cut from 35% and 58% in 1988 to 20% and 42% in 2002.
• Difficult to disentangle cause and effect.
• Tax cuts in recent budgets increased the supply of labour and
stimulated aggregate demand.
• Government expenditure under the 1994 and 2000 National
Development Plans was €28 billion and €51 billion respectively.
• Expenditure went into improving infrastructure (road conjestion),
environmental pollution, education and training, and housing.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
6. World Economy
• Ireland is very open to trade.
• Non-EMU countries account for 80.4 % of Irish
trade.
• Very dependent on the US economy. Exports of
€1.6 billion in 2001.
• Economic performance in USA has been major
factor behind the growth in Ireland.
• Current slowdown in Ireland is due in large part
to slowdown in US, terrorist attack 11th
September and the foot and mouth disease.
• Tourism increased by 8% per annum throughout
the 1990s.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
7. EMU Entry Criteria
• To join EMU, Irish inflation had to drop to below 2.7 %.
• Hence, EMU forced the government to adopt an antiinflationary stance.
• EMU membership also entailed a fall in Irish interest rates
down to the low German rates.
• By the late 1990s, negative real interest rates stimulated
the demand-side of the economy and fulled house price
inflation.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
8. Exchange Rate Policy
• Over-valued exchange rate combined with high interest
rates can seriously curtail a country’s growth potential.
• Devaluations in August 1986 (8%) and January 1993
(10%) prevented over-valuation.
• Central Bank followed a policy of stabilising the effective
exchange rate.
• Involved playing off the strength of sterling against the
weakness of the DM. Middle ground.
• From August 1997, the DM rate was allowed to drift down
to the EMU entry rate of 2.4834.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
9. Small is Beautiful
• Obviously a lot easier to turn around a small country
like Ireland than a very large country.
• The same level of foreign direct investment would
have much less of an impact on, say, the Spanish
economy.
• Factor number 10 was “luck”. Most of the above
mentioned factors complemented each other in moving
in the right direction at the right time.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
How Did these Factors Influence
Output?
•
•
Examine how factors 1 to 9 impact on the
demand-side (AD) and the supply-side (AS) of
the economy.
This analysis is subjective because:
1. Some factors impact on both AS and AD.
2. The factors interact with each other.
3. It is virtually impossible to quantify the effect of each
factor on economic growth, unemployment and
inflation.
LRAS
• Long-run (natural real GNP) and short-run AS curves are
determined by:
– A. The size of the labour force.
– B. Physical and human capital.
– C. Advances in technology.
• Some of the Policies affect AS
1.
2.
3.
4.
5.
6.
Foreign direct investment 
External assistance

Investment in education

Centralised wage bargaining
Fiscal policy
World economy
Affects B and C.
Affects B.
Affects B and C.
Short-run AS curve.
 Affects A, B and C.
 Affects B and C.
• Result: the long-run and short-run AS curves shift to the
right.
AD
• AD curve is determined by: Consumer
expenditure (C), Investment (I), Government
expenditure (G) and Net exports (NX).
• 5. Fiscal policy

affects C, I and G.
• 6. World economy
 I and NX.
• 7. EMU entry criteria  C, I and NX.
• 8. Exchange rate policy  NX.
• Result is a shift of the AD curve to the right.
Overall
• Equal movement of the AS and AD curves resulted in very
fast real growth rates with little or no effect on inflation.
• 1994 – 2000.
• Average real growth rate = 8%
• Average inflation rate = 2%
• If the shift in AD > shift in AS, inflation would have
increased by considerably more.
• Employment increased from 1,118,300 in 1993 to
1,745,000 in 2002.
• Unemployment rate fell from 14.5% to 3.6%.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Graphical Representation
Natural real
GNP
Inflation
AS1
 AS2
1
 AD1
 AD2
Real growth rate
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Q5
•
During the 1993 currency crisis, the Irish
government resisted devaluation for some
time. Discuss the origins of the crisis. Was
the government correct to resist the
devaluations? Discuss the economic
effects of this resistance and the eventual
devaluation. Be sure to illustrate your
answer with the appropriate diagrams.
Currency Crises
• UIP & Competitiveness help explain how
currency crises arise.
• Basic story for any crisis
–
–
–
–
–
Country in a recession with fixed e rate
Markets expect that gov will devalue to boost AD
Expectation of devaluation leads to higher interest rates
Makes recession worse
Speculators try to sell their holdings of the domestic
currency
– Self fulfilling prophecy
– Devaluation usually but not always occurs.
Origins EMS Crisis 1992/3
• Objective is to stabilise exchange rates.
• Key point is that for the system to work,
there must be similar inflation, interest rates
and growth rates.
– German unification ensured that there wasn't
• German unification in 1990 lead to huge budget
deficit.
– Could not be financed by increasing taxes
– AD shifts right.
• Bundesbank raises interest rates to combat
inflation
– i (by 3%).
– AD shift to left
• Because of fixed exchange rates, the increase in
interest rates was transmitted to rest of Europe
– The FP was not
– Everyone else’s AD shifts left.
• Europe has recession (worse for UK)
Germany 1992
LRAS

SRAS(e)
AD1
AD0
Y*
Y
UK & Ireland 1992
LRAS

SRAS(e)
AD0
AD1
Y*
Y
The Irish Pound and the Crisis
of 1992-93
• Example of SOE
• Sterling’s dropped EMS in September and the
currency depreciated by 15%
• However, the Ireland was only coming out of
a long recession
– Unemployment was 12%
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
• Speculators took view that DM/IR£ e was not
sustainable.
– Expect that gov will boost AD by devaluation and/or
reduction in interest rates
– Especially true once sterling depreciated as now Ireland
lost competitiveness in main export market
– Speculators Try to sell IR£ and buy DM
• Situation becomes self re-enforcing
– As speculators fear a devaluation, sell IR£ (supply
increases)
– CB has to use up more reserves
– Anticipation of devaluation pushes up int rates making
recession worse, making devaluation more likely
£/DM
S
e*
E above
market
value. CB
must buy £
with DM
D
£ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
19
92
M
19 5
92
M
19 6
92
M
19 7
92
M
19 8
92
19 M9
92
M
19 10
92
M
19 11
92
M
19 12
93
M
19 1
93
M
19 2
93
M
19 3
93
M
19 4
93
M
19 5
93
M
19 6
93
M
19 7
93
M
19 8
93
M
9
%
Irish and German interest rates during the currency crisis
45
40
35
30
25
20
15
10
5
0
Implications of the No
Devaluation Stance
• If continued lead to recession
– e was overvalued
– i high in anticipation of devaluation
– Both shift AD to left
• The Central Bank’s external reserves fell from £3.05 billion at the end
of August to £1.07 billion at the end of September, despite significant
foreign borrowing.
• Short-term interest rates were raised to unprecedented heights to
defend the currency from speculative attacks.
– One-month inter-bank interest rates peaked at 57 per cent on 12 January
1993.
– Overnight interest rates on the Euro-Irish pound market rose to 1,000 per
cent.
• The combination of an overvalued currency and penal interest rates
was seriously damaging the Irish economy.
• Eventually had to devalue
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
The Alternative to Devaluation
• The over-valuation of the sterling/Irish pound exchange
rate results in a loss of competitiveness relative to the UK
and this reduces Irish exports and increases imports.
– This shifts the aggregate demand (AD) curve down to the left.
– Real wages increase because the inflation rate falls while the
nominal wage remains unchanged.
• If workers were to accept a cut wages nominal wages so
as to restore the original real wage, the aggregate supply
(AS) curve would move down to the right.
– The economy would return to the natural real growth rate.
– Same argument as with any recessionary shock
– Workers are not any worse off because the original real wage has
been restored.
• Devaluation is easier to implement
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Ireland alternative to devaluation 1992
LRAS

SRAS(e)
AD0
AD1
Y*
Y
Q6
• SGP vs Golden Rule
The Golden Rule
Over the business cycle the government should
borrow only to invest and not to fund current
spending
No current deficits over the business cycle,
but automtaic stabliser is allowed. So can have
deficit in recession year as long as paid back in
boom
Future generations should contribute to the
costs of infrastructure from which they
benefit
So can borrow for capital projects even in
long run
We adhered roughly to this rule in Ireland
until the late 1970s
The Golden Rule
The threshold between current and capital
spending is not hard-and-fast
Education?
Health? Etc
Until recently government capital formation
account for borrowing equal to about 4.5% of
GDP
The SGP
• Attempt to implement something that
looks like the golden rule
• Fiscal deficits should average at most 1%
of GDP over the business cycle
• Deficits in excess of 3% of GDP will
attract penalties unless they were due to
“exceptional” and/or “temporary”
Could imply pro-cyclical transfers from
countries to the centre.
– Fiscal federalism in reverse
SGP
• Countries have to prepare a Stability
Programme when presenting their
national budgets
• This Programme contains
projections of General Government
Balance for four years showing that
national fiscal policy respects the
SGP
SGP
• Ireland was reprimanded in 2001
because the Council felt that Budget
2001 was too expansionary
Charlie McCreevy v Pedro Solbes
• But the stagnation of the Eurozone
economy during 2002 has lessened the
appetite for enforcing the SGP
Portugal, Germany, Italy, and France at or
above the 3% ceiling
SGP
The deadline for reaching a balanced
budget postponed from 2004 to 2006
Then France ignored SGP in formulating
its 2003 Budget
What to do about the SGP?
Scrap it?
Some argue that it is irrelevant because small
deficits incurred during periods of slow growth
are not a threat to the euro
The initial weakness of the euro was not due to
fears about the level of government borrowing
It may also be argued that Europe needs a
growing stock of government debt
What to do about the SGP?
Modify it?
Move to a “cyclically adjusted” budget
balance, taking account of the automatic
stabilisers that depress revenue and raise
spending during a slowdown
What to do about the SGP?
Stick with it?
Don’t risk the loss of credibility involved
in abandoning the discipline of the SGP
when it faces its very first crisis.
Regard compliance as a test of the
commitment to the euro.
Conclusion
There is need for a rule, but a rigid one is
undesirable
We have to bear in mind the uncertainty of
projections of GDP, tax revenue, and public
spending
Rules force the present generation to pay for the
level of spending on (current) public services it
desires
Q7 Bubbles and Nama
• It turns out that this is a very long question
so unlikely student would get all this
material down
a) Evidence of bubble
• Bubble is sustained price increase substantially
above the “fundamental value”
– not just a rapid price increase. This could be
justified
– Sustained: not temporary blip
Fundamental Value
• Long term value concept
– Determined by rational analysis of other
variables: income, interest rates etc
– Notion is that the relationship between
variables does not change over time
• The opposite of New Era story
• Income should be a driver of house prices
– Price clearly out of line with this
“fundamental” after 1997 in Ireland
50000
1970
1980
1990
2000
2010
year
real
inc
2020
• As always there are a “New Era” counter
arguments
–
–
–
–
–
Growing economy
Immigration
Housing stock
Irish people pre-disposed to ownership
Low interest rates
• A more complicated model can take account of
these factors
– Same result: price out of line with fundamentals
b) Effect on banks
•
The outline of the story is well known.
–
–
–
Banks in several countries may too many
loans to the property market
These loans have now gone bad as the bubble
has burst
The banks are now in financial trouble and
have to be rescued by governments
Bank Balance Sheet
Assets
Cash
Loans
Banks
Companies
Individuals
Liabilities
Deposits from
the Public
Bond holders
Equity (Capital)
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Role of Equity
• Crucial to the way bank operates
• The idea is that if banks suffers losses they are
absorbed by the shareholders not the depositors or
bond holders
• Therefore equity has to be large enough to absorb
expected losses
• This is the money you have to put down in order to
own a bank
• Common sense and regulation require a certain level
– “reserve ratios”; “Capital requirements”; “Tier 1”
• Banks want the ratio as low as possible as it
means can lend out more
• The lower ratio allows bank to take in twice
the deposits for the same level of commitment
from shareholders
• Profits higher
• Risk higher because cushion lower
– Smaller bad debts would bankrupt the bank
Key Issue: Solvency
• One of the key issues in the banking crisis was that
the cushion was too low
– Banks like small cushion because higher profits
– But higher risk also
• This was a failure of regulator and banks own risk
management
– Should have realised property lending risky because of
bubble
• Regulator require higher cushion
– Reduces profits so lending to property slows down
– Canadian approach
The problem
• Huge reliance on property and on
development in particular
• Bubble bursting creates huge potential for
losses
– Particularly so in development loans
– What NAMA is now concentrating on
• banks aware of this potential & try to
assuage investors fears
– Say LTV is 65%
Solvency
• LTV is important
– Indicates how much the bank could get back if
borrower defaults
– One of the key assumptions of NAMA
• As long as they have declined by no more than
35% bank will get its money back
• Bubble graph suggests that prices were twice
fundamentals
– expect decline of 50%
Bad Loans
• What happens when loans go bad?
– Small losses: handle as “bad debts”
– Medium losses: Zombie bank
– Large Losses: bankrupt
Zombie Bank
• Losses wipe out lots (but not all) of capital
• Bank remains solvent but cannot operate effectively
• Bank will probably continue in existence
– But limited lending
– Remember the role of equity – has to cut back on lending
– Zombie bank: not dead but not alive either
• Solution: Get more capital from markets or government
– Dilute shareholders wealth
– So shareholders may prefer zombie
• Japan during 1990s
Bankrupt
•
•
•
•
Now suppose even Bigger Losses
This is more than the shareholders funds can absorb
Bank bankrupt: cannot continue in operation
Any other business all creditors take a hit in proportion or
priority
• This means that depositors would loose 10% of savings
• To avoid this the government usually steps in some way
• Rational for NAMA-like arrangements
c) NAMA
• Don’t want banks bankrupted for two reasons
– To avoid depositors taking a hit
– Banks central to economy so formal bankruptcy (even
temporary) is very disruptive
• So government needs to deal with hole in the banks
• Need to decide three related Q
– How big is the hole?
– who pays?
– What is done with the banks afterwards?
Who Pays?
• Someone has to
• 4 possibilities
– Depositors: want to avoid at all costs
– Shareholders: “rules of capitalism”
– Bond holders: rules also
• 4th possibility Tax payers
– Make up gap if share and bond holders not enough
– It looks like NAMA has taxpayers take on some of the
losses even without share and bond holders funds being
exhausted
– We will look at whether this is necessary
What happens to Banks?
• After the losses are dealt with banks will need
sufficient capital to work with
– Avoid zombification
– After NAMA: AIB, BOI <4% (JP Morgan)
– 10% now standard internationally
• Certain that they will not have enough on their own
– Shareholders will absorb some losses
– International practice now requires more capital
• “Recapitalisation” can happen
– Via market: rights issue BofA
– Via government share holder: RBS 80% owned by UK
– Overpayment: NAMA pays €54bn for €47
•
•
•
•
How Big is the Hole?
How much are the bad debts of the banks?
IMF estimated them at €35bn
Probably a low estimate
Government is more optimistic
– Assume LTV 77%
– Assume prices reached bottom and will rise 10%
– Lead to a conclusion that NAMA will make a
profit
Three Key Assumptions
• LTV=77
– Anecdotal evidence of 100%
– Use other property as collateral for the loan
– If 100% then the original value of the collateral
was €68bn
• 47% decline
– Maybe €21bn in land where decline has been 95%
– 34% of loans outside Ireland
– So final loss could easily be higher than the
government predicts
• LTEV will be €54bn
– Rationale for overpayment
– Based on assumption that prices rise by 10% from
current level
– 10% reasonable
– is the current level the bottom?
• Probably not!
• Even bigger loss
A Comment
• Any prediction difficult
• Govt seems optimistic but possible
• Real issue is not the numbers but how it is structured
and who takes the risk
– Why over-pay?
– Why not take shares in the banks?
– Why not have bond-holders pay the price?
• Under NAMA tax payer bears risk of asset values
– There is a notion of future levy
Consequences for Banks
• See balance sheet
• Loans decline by €77bn
• Banks paid €54bn in bonds that may be
exchanged for cash at ECB
• Losses of 77-54 absorbed by shareholders
• Capital ratio below 4%
• Need capital injection of €30bn
– Market or government
Mortgage lenders Sept 09
After NAMA
Assets
Liabilities
Cash etc
76
Deposits 571
Loans
556
Others
Total
60
692
Equity
Debt
21
110
Total
692
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Consequence for the Taxpayer
• Govt already spent €7bn on capital injection to banks
in return for preference shares that pay 8%
• Overpayment is a form of recapitalisation
– Without pref shares and overpayment equity would be only
€7bn
– No ordinary shares in return
• State guarantees all liabilities of banks
– Taxpayers bears all the risks of business
– Get very little return
• In the end taxpayer will provide almost all the capital
of the bank but will (likely) have less than 100%
shares
Alternatives
• What are the alternatives?
• Any sensible alternative is going to look at lot
like NAMA
– Segregate bad assets from good
– Some government involvement
• The big differences among the alternatives is
who pays what and who bears the risk
Alternative 1: Nationalise the Banks
• Wipe out the equity holders
• Admit that total losses are likely to be more than the
current shareholders funds
• Risk to taxpayer reduced as we now have assets as
well as liabilities
• Consequences
– Overpayment no longer matters
– Total losses to be absorbed by the state will be less by the
amount of the equity
– Taypayer will get the value of the future business of the
bank to offset losses
Arguments Against
• Unfair to shareholders
– Maybe if losses actually less than equity
– Unlikely
– Retrospective compensation possible
• Too expensive because share price is too high
– Lenihan made this argument
– Clearly nonsense
– Price is only above zero because of NAMA
• Nationalised banks become politicised
– True
– Re-privatise early
– Very expensive way of avoiding corruption
• Foreigners will not deal with nationalised banks
– Maybe true for some but not generally true
– In any case will not deal with any bank without state
guarantee so seem unlikely to object to state ownership
• Doesn’t get rid of the losses so is irrelevant
– True that losses remain
– But get share (or all) of future profitable business to offset
losses
– Eg €7bn overpayment or for shares
• Nationalisation hurts reputation
– Banana republic
– Other countries have done it UK
– Partial possible
• Nationalisation will lead to higher risk
premium on corporate and national debt
– Anglo cited as evidence
– Premium already up because of extent of bad debts
– Idea is that nationalisation would increase it
further
– No evidence that ever happened before
Alternative 2: Bond-holders
• In addition to wiping out equity holders we
could force bond-holders to take some of
losses
• Could even force them to take all the losses
(after equity)
– Mirrors normal bankruptcy
– Joseph Stiglitz & Morgan Kelly
– “Debt-equity swap”: INM
• Minimises cost and risk to taxpayer
Arguments Against
• Bank financing premium in future
–
–
–
–
Maybe true
Cost to banks
Pass on to society in short run
In long run foreign Competition will mean no cost
to society
• Pension funds loose out
– Mainly foreigners
– deal with pension funds directly
• Sovereign Risk
– Defaulting on the bank debt will be seen as
equivalent as defaulting on national debt
– Big issue: risk premium of national debt will
increase: huge cost
– Plain wrong: no evidence of it internationally
– Makes no sense: sovereign risk premium rose
when we took on the bank liabilities (guarantee)
and bad assets (NAMA)
– Why would the risk increase if we hand-back those
liabilities.