LIMERICK INSTITUTE OF TECHNOLOGY

Cyclical Trends in Construction and Property.

3rd Yr. Quantity Surveying 2011-2012.

Draft no.04

Author: Brian O’ Hanlon.

K00123106

2/29/2012

The year 2008 will be remembered in Economic History as one of the most turbulent and volatile periods for the world’s financial systems in general, and for the Irish Construction and Property industry in particular. Now in 2011-2012 the consequences of that collapse in the property and construction boom are being fed through into instability in the Eurozone itself.

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C o n t e n t s

Contents .................................................................................................................................................. 2

Table of Figures ...................................................................................................................................... 4

Study of Economic Bubbles .................................................................................................................... 6

Bubbles – Historically speaking. ........................................................................................................ 6

Bubbles - This Time it is different. ..................................................................................................... 9

Study of Subprime mortgages ............................................................................................................... 14

The Sub-Prime mortgage market. ..................................................................................................... 14

The effects of the Sub-Prime mortgage market collapse. ................................................................. 17

Who is to blame? .............................................................................................................................. 20

What is Euro zone? ........................................................................................................................... 25

The Eurozone and European or International Policy Making. .......................................................... 27

Study of Irish Economics ...................................................................................................................... 33

The Irish Bubble. .............................................................................................................................. 33

The Irish Bubble and its Underlying Factors. ................................................................................... 37

The Irish Economy and Eurozone crisis. .......................................................................................... 44

Study on NAMA ................................................................................................................................... 49

NAMA’s role. ................................................................................................................................... 49

What is NAMA supposed to fix? ...................................................................................................... 55

W o r k s C i t e d ............................................................................................................................ 58

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T a b l e o f F i g u r e s

Figure 1 - Index of Japan nationwide land prices. .................................................................................. 6

Figure 2 - Financial industry profits as a share of US business profits. .................................................. 7

Figure 3 - UK real average earnings. .................................................................................................... 11

Figure 4 - Reversing origins of US corporate profits, 1950-2004. ....................................................... 13

Figure 5 - Unconventional Monetary Policies, US Federal Reserve Bank. .......................................... 23

Figure 6 - Explosion of fiscal deficits as a percentage of GDP. ........................................................... 31

Figure 7 – Skyline of Dublin Docklands Area in 2000's. ..................................................................... 33

Figure 8 - Monthly house completions, based on ESB electricity connections. ................................... 34

Figure 9 - Property lending in billions of 2009 Euro, 1993-2009. ........................................................ 35

Figure 10 - Evolution of credit in Irish economy, Y-axis shown as millions of euro. .......................... 38

Figure 11 - Average first time buyer mortgage and new house prices, relative to average earnings.... 39

Figure 12 - Surplus capital exporting countries. ................................................................................... 40

Figure 13 - Foreign currency intervention: global currency reserves. .................................................. 41

Figure 14 - Consumer debt service ratio. .............................................................................................. 42

Figure 15 - Portugal, Ireland, Greece and Spain. .................................................................................. 44

Figure 16 - Housing Investment as a percentage of GDP. .................................................................... 45

Figure 17 - General Government Balance, as per cent of GDP. ........................................................... 45

Figure 18 - Lost competitiveness in periphery, Unit Labour costs, relative to Germany. .................... 46

Figure 19 - Ireland’s projected Debt to GDP ratio. ............................................................................... 46

Figure 20 - The Five Irish Lending Institutions. ................................................................................... 50

Figure 21 - Loan book by loan type. ..................................................................................................... 51

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S t u d y o f E c o n o m i c B u b b l e s

B u b b l e s – H i s t o r i c a l l y s p e a k i n g .

Describe, using examples from past economic experience throughout the world,

what is meant by an Economic ‘bubble’?

Bubbles have occurred in developed economies since the very beginning. My professor in architecture

school in Dublin in the 1990’s used to like to tell the story of ancient Egyptian economy and the

pyramids. The economy had become so wrapped up in building these structures, that the Pharaoh’s

couldn’t stop, or risk crashing the whole economy. Professor Morgan Kelly, a keen observer of the

Irish economy in the period of the early 21st century, might draw a similar observation about Ireland.

(Kelly, 2009) (Reinhart & Rogoff, 2009)

Figure 1 - Index of Japan nationwide land prices.

Source: David Harvey. (Harvey, 2010)

Professor Kelly of UCD made a historical study of bubbles that occurred in Japan in the 1980s, and

the Irish agricultural land bubble following entry into the European Union in the early 1970s. It was a

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popularly assumption in Ireland in the 1970s that having gained access to large markets for

agricultural produce, all of the farmers in Ireland would become rich. It resulted in of over investment

in new equipment, infrastructure and agricultural land (purchased using credit). The aftermath in the

1980s saw many farmers going bankrupt.

According to Woolley (Biais, Rochet, & Woolley, 2010), the Financial Industry itself is a bubble,

absorbing absurd amounts of capital and human resources. Banking and finance is the world’s largest

industry accounting for 10% of GDP in the US and UK. Woolley refers to it as ‘rent capture’, or the

ability of the middle man to earn excessive profits. (Biais, Rochet, & Woolley, 2010) (Stiglitz &

Nations, The Stiglitz Report: Reforming the International Monetary and Financial Systems in the

Wake of the Global Crisis, 2010)

“It isn’t just that the agents are in a position to capture the bulk of the gains from financial

innovation because they are at the intersection of the saving and investment processes for the

entire economy. They have the potential to extract the bulk of the returns from the entire

productive economy. They can bleed the economy dry”. (Woolley, 2010)

According to Woolley (Biais, Rochet, & Woolley, 2010), until 2005, one could explain the price of

any individual commodity – wheat futures, pork bellies, aluminum, freight rates, oil or whatever – by

supply and demand in relation to the underlying commodities. But the search for alternative

investments by giant investment funds in the late 2000’s has caused distortions in the market for

commodities. Which has messed up all of the signals for consumers of commodities themselves.

Figure 2 - Financial industry profits as a share of US business profits.

Source: Simon Johnson, Atlantic Montly. (Johnson, 2009)

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Soros (Soros, 2008) commented on the commodities bubble in emerging countries in the later 2000’s.

Which resulted in a lot of capital flowing from the centre of the financial system to the emerging

countries.

In the aftermath of September 2008, US Secretary of the Treasury, Hank Paulson, was forced to

guarantee deposits in order to give people at the center of the system confidence. But it also had the

consequence that a flood of capital rushed from the periphery to the center. The periphery got hit

again. (Soros, 2008)

George Soros, lifelong hedge fund manager and owner of the Quantum Fund has published works in

recent times about what he calls the ‘Super Bubble’. Many other bubbles such as the dot.com

technology stocks bubble and the US Sub-Prime mortgage securities bubble, fit inside the ‘Super

Bubble’ according to Soros.1 (Soros, 2008)

1 I recommend that readers also pay close attention Professor David Harvey’s theory about the internal contradictions of capital surplus accumulation, which I describe later in the document. It is an alternative and interesting theory to do with innovation in consumer lending from the 1970s onward.

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B u b b l e s - T h i s T i m e i t i s d i f f e r e n t .

Why, despite the fact that this phenomenon has been experienced numerous t imes in

the past , is i t so dif f icult for market players in a bubble to correctly assess the

nature of the market they are participating in unti l af ter the ‘bubble’ bursts?

Paul Krugman described the inability of economists and policy makers to see the housing bubbles in

America of the 2000’s, as one of the most depressing things ever – prices were out of line with any

notion of the fundamentals. (Krugman, 2009, June 09) At least the technology bubble of the 1990’s

was something completely new. We did not know how to value it properly. But housing markets have

been around since the Sumerians.2 Why did people suddenly believe the old rules no longer applied to

the housing market?

Harvey does not believe it is possible to have a crisis free capitalism. Professor Harvey cited the most

recent World Bank development report – the best thing that you can do, is let the market rage. This is

the advice as handed down to countries all around the globe. You can clean up the mess after the

bubble has been created and has gone. (Harvey, 2010)

Harvey suggests the only way that we will be able to avoid future financial crises and bubbles

occurring, is to have social control over the surplus produced by the capitalist system. In Harvey’s

theory, economic bubbles may be an inevitable consequence of capital accumulation. (Harvey, 2010)

It is worth spending some paragraphs to look at the concept of what George Soros has termed the

‘Super Bubble’. There are several components of the super bubble. The expansion of credit made

possible by the growth of the financial services industry. The creation of more and more sophisticated

ways in which to employ financial leverage – to place larger and larger gambles. The globalization of

financial markets is another component. (Soros, 2008)

According to (Reinhart V. , 2011), the most frequent phrase used by Hank Paulson in US

Congressional testimony in 2008 was: “Before Asian markets on Monday”.

2 The cities of Sumer were the first civilization to practice intensive, year-round agriculture, by perhaps c. 5000 BC showing the use of core agricultural techniques, including large-scale intensive cultivation of land, mono-cropping, organized irrigation, and the use of a specialized labour force.

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The doctrine of market fundamentalism played a role in the creation of the super bubble. The

misconception of regulators and governments that markets can correct their own mistakes. The cost of

financial innovation is that you are going to have occasional bubbles, and you pick up the pieces

afterwards. Periodic financial crises and their subsequent resolution by governments only served to

reinforce the misconception. (Soros, 2008)

Financial crises such as the ‘Savings and Loan’ in the United States in the 1980s served as successful

tests of the misconception. In 1998, the leveraged hedge fund, Long Term Capital Management was

about to default – but the system was held together by the successful intervention of the US Federal

Reserve. After the 1998 crisis, it was peripheral economies such as that of Indonesia which suffered

the most damaging after effects – not the United States economy. (Soros, 2008)

The belief was reinforced that capital was safe at the centre of the financial system in the markets of

the United States. The United States was able to suck up all the savings of the world. (Soros, 2008)

How or why did the huge expansion in consumer lending that we witness today in modern society

come about? One explanation is ventured by Harvey (Harvey, 2010), who said labour (the workers

who produce goods, that creates the surplus known as capital), became weaker from the 1970s

onwards.

One of the first attempts to break labour, was through means of immigration. In the mid 1960’s, the

United States revised its immigration law to allow itself access to the whole global labour market.

That proved to be politically unpopular. It created competition on home soil for employment.

The United States then tried off-shoring of jobs. In order to do that, ways for capital to pass across

national boundaries was needed. What the United States required was the opening up of new financial

architectures starting from the late 1970s and early 1980s onward. Even the threat of off-shoring of

jobs began to discipline labour.

Capital needed to go where the most disciplined labour force existed. The currency futures market in

Chicago begun in 1972, was essential for pursuing a solution to the labour problem.

By the mid 1980’s according to Harvey, the labour problem is essentially solved from a capital point

of view. (Harvey, 2010) Capital had access to massive labour reserves all over the world. One can

read the work of Naomi Klein also for illustration of this point. (Klein, 2002, April 06)

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From the point of view of a US multinational, the most disciplined labour force existed in the

developing world, and in places such as Ireland. What has been the net result of all of this movement

of capital to continue with cheap labour resources?

Figure 3 - UK real average earnings.

Source: National Statistics Office, UK.

The wage share of national income has been steadily declining in all OECD countries since the 1970s.

(Harvey, 2010) (Stiglitz, 2006) Wages have even been declining in China. In this environment, where

is the market for goods going to come from? Where is one going to sell produce? Harvey explained

the solution to this crisis, dictated the terms of the present day one.

The solution to the lack of markets for produce, was to give everyone credit cards. It is what Harvey

calls ‘the organization of a debt economy’. Households in the United States tripled their indebtedness

over the last 30 years. The indebtedness also occurred in a situation where wages levels were

declining.

Competition between capital, meant that profit margin on goods sold went down. By the late 1980s, a

low wage economy and a low profit margin economy had been created. This suited Ireland for a brief

period known as the early phase of the Celtic Tiger in the 1990’s when our economy was competitive

and based around manufacturing and exports, rather than on household consumption and property

speculation.

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“While the boom lasted, to get the resources it needed the building sector outbid firms that were

exporting. The effect of the rapidly rising costs, especially wages, was that firms that depended

on export markets were closing even in the good times. Because of the general buoyancy in the

economy these losses went unnoticed”. (Fitzgerald, 2009)

Why would capital wish to invest in a low profit margin economy? Capital began to invest instead in

other things. New markets for assets which had never existed before. Markets which do not clear

themselves in any ordinary sense. Markets where one could make money out of money. Later in this

study, the Sub-Prime mortgage market in the United States will be discussed.

Markets in derivatives, markets in insurance on derivatives, derivatives on insurance on derivatives –

and so on. At the height of the financial crisis of 2008, the five largest hedge funds in the United

States each earned $30 billion a piece. That is where capital was going, because it could not find good

markets to make things that people really need. (Soros, 2008) (Harvey, 2010) (Wolf, 2011, March 16)

A lot of savings from all across the globe ended up in the United States, because it was supposed to

have sophisticated markets that knew how to invest the savings well. That turned out not to be true.

(Krugman, 2009, June 09) In fact, the United States had no idea what to do with the capital. (Wolf,

2011, March 16)

In the future the American financial industry will not represent 25% of the market capitalization of the

New York stock exchange. The shadow banking system will be absorbed back into the regulated

investment banking system. The hedge fund industry will go through a shakeup and be dramatically

reduced in size.

Having 40% of all US corporate earnings in the financial industry was an excess. With increased

regulation, certain business models which relied on excessive leverage, such as Long Term Capital

Management, will prove to be unworkable. (Soros, 2008) (Stiglitz & Nations, The Stiglitz Report:

Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis, 2010)

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Figure 4 - Reversing origins of US corporate profits, 1950-2004.

Source: David Harvey. (Harvey, 2010)

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S t u d y o f S u b p r i m e m o r t g a g e s

T h e S u b - P r i m e m o r t g a g e m a r k e t .

Describe fully the evolution of the sub-prime mortgage industries collapse in the

United States.

A notable economic commentator in the United States, Peter Schiff, suggested that in the 2000’s in

America – if one wanted money one bought a house. Mr. Schiff points out, that you needed more

paper work to rent a home in California in 2006 than to buy a home using a bank loan. (Schiff, 2006) 3

One did not need to any money down as deposit to purchase a home. One could buy with credit and

wait as the value of the investment rose. (Shiller, 2008)

According to Harvey, the largest failed state in the world today, is California. If it were not for federal

state transfers, California would be ‘completely wrecked’. (Harvey, 2010) (Harrison, 2007)

Harvey points out, the tax relief on mortgage interest payments, offers huge advantages to the middle

classes in the United States. The larger the mortgage debt of the American citizen the more interest

you are paying, the more interest tax relief you receive. (Harvey, 2010) 4 The percentage of home

ownership the United States is over 60%. In other wealthy countries such as Switzerland it is only

20%. (Harvey, 2010)

When we hear the term ‘Sub-Prime’ nowadays, we tend to think about Wall Street, corruption and the

financial meltdown. But the Sub-Prime mortgage was heralded as a fantastic innovation. It offered to

millions of young Americans who may have overdrawn their credit cards in their youth – and thereby

3 An astonishing amount of what Schiff describes about California in the 2000’s, also sounds familiar from an Irish or UK residential market perspective. (Kelly, 2009) 4 In this study, I did not have time to bring in the input of American socialist thinker and author Mike Davis. See bibliography at end, for a PBS interview on the Bill Moyers show, in which Davis discusses the involvement of labour in America as part of the solution that president Roosevelt negotiated in the New Deal era. The agreement in the 1930s in America between capital and labour, which Davis believes is not happening in the early 21st century in the United States. Also refer to the work of Harvard professor, Elizabeth Warren, and her extensive studies into the state of the middle classes in the United States today, for additional points of view.

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ended up with a poor credit history rating a means to access credit to buy homes. The Sub-Prime

innovation gave many people a route back towards home ownership.

Geanakoplos (Geanakoplos, 2009), explained that you can never find $1.0 trillion worth of people

willing to lending to subprime borrowers. This is where the innovation of financial intermediation and

risk management stepped in to assemble the credit in the quantities necessary to develop a solution

such as the Sub-Prime mortgage. The whole idea behind securitization is that one doesn’t need to find

$1.0 trillion’s worth of lenders.

By splitting the mortgage securitization into tranches of different risk ratings, of the $1.0 trillion of

creditors, approximately $800 billion were buying a low risk investment. It was only the 20% who

were taking on the much higher level of risk, were paid premiums for their risk investment. The whole

idea of the American financial system, was to create cash flow for the people in the states that wanted

it. (Geanakoplos, 2009)

The financial sector fabricated on an incredible scale these ‘safe’ higher yielding assets – which

satisfied the ‘reach for yield’ by investors – who were struggling to find returns for capital in the

extraordinarily low real and nominal interest rate conditions of the post dot.com years. Wolf believes

that German banks purchased more US Subprime mortgages than American banks did. The ‘safe’

assets turned out to be anything but safe. (Wolf, 2010)

According to Simon Johnson the additional profits of the financial sector in the last decade have come

for the most part from dealing in the more exotic securities, assets and markets which had never

existed before in the financial system. (Johnson, 2009)

As soon as house prices in the US began to slide, the short comings of the risk models was revealed

by losses on such a scale, that they threatened the solvency of the world’s major banks. The losses

were out of proportion with the banks cushion of shareholder capital to absorb losses. Swiss bank

UBS for instance, a leader in the use of risk management models, lost $44 billion.

Professor Patrick Honohan, the Governor of the Irish Central Bank, speaking in December 2008

provides an explanation of why risk management failed so spectacularly in banks throughout the

globe. (Honohan, 2008, December 02) Honohan understood that banks were using risk management

tools to build very complex transactions.

At first the risk management tools performed well by generating accurate predictions of risk, and

spreading the risk amongst many lenders. This has allowed banks and financial institutions to conduct

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new kinds of business with apparent safety. But the risk management tools were pushed well beyond

their true capabilities, being employed to assess the riskiness of increasingly complicated and

unproven transactions. 5

It was the level of confidence placed in these tools which resulted in their becoming a kind of ‘Trojan

horse’. Basel II (Bank for International Settlements, 2004), according to Honohan is dead on arrival,

being the embodiment of the over confidence in mechanical risk management tools.

There should be 5% capital in any institution regardless, and it should be equity capital. We got into

more and more trouble because risk-based capital became the measurement. (Fish, 2009, September)

If capital is to be used to take overnight positions in foreign exchanges, or to take derivative positions,

or to invest in an automobile company in China, then capital has to be very high. (Fish, 2009,

September)

5 Economist Nouriel Roubini turned out to be one of the most accurate predictors of the crisis of 2008. Honohan had dismissed the early analysis of ‘Doctor Doom’ Nouriel Roubini, because Roubini had no particular expertise in banking and risk management, being a macro-economist. (Honohan, 2008, December 02)

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T h e e f f e c t s o f t h e S u b - P r i m e m o r t g a g e

m a r k e t c o l l a p s e .

Demonstrate how this collapse had severe consequences for the wider f inancial

services industry in the USA and elsewhere in the world.

Larry Fish said, it was the first time in his forty years of banking, that there was a crisis in consumer

lending. Consumer lending had always been easy to underwrite, and never had any serious problems.

In the past it was always commercial credit which had caused the crises in the banking industry. (Fish,

2009, September)

This crisis was not caused by any external shock, such as the lack of supply of oil as had occurred in

the 1970s. This was a crisis that originated at the center of the global financial system. (Soros, 2008)

Geanakoplos says the third quarter of 2006 was the peak of the Subprime mortgage market and that

by early 2007 it had collapsed. By November 2007, the stock market in the United States had also

collapsed. Geanakoplos says that traders had figured out something bad was ‘going to happen’.

(Geanakoplos, 2009) The Subprime market was only $1.0 trillion in size. But there were all kinds of

insurance written on it also – by those same banks who had announced losses at accelerating rates by

December 2007 and early 2008.

Geanakoplos noted that securitization had made investing in ‘Mortgage-backed securities’ much safer

by the 2000’s, and that financial institutions were buying them using leverage. Insurance companies

were big buyers of MBS’s, but the price got so high they stopped buying. Instead they purchased

‘Credit Default Swaps’, which enabled a pessimistic investor to express themselves in the market.

(Geanakoplos, 2009)

Large investors began to ‘bet against’ the market for Subprime mortgages starting in 2005 – and soon

the Subprime market went down. MBS’s went down so far in price new securitizations were not

worth it any longer. If new MBS’s were sold at a lower price, there was no money to lend to the

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Subprime borrower. In order to make the MBS’s sell for a higher price, issuers of new bonds

demanded that homeowners put up more capital. 6 (Geanakoplos, 2009)

In 2007 Subprime borrowers who could have re-financed their loans using only 3% down, were asked

to put 25% down instead. In 2007, people all stopped re-financing their loans. They got stuck with the

old loan, which then was ratcheted up to higher interest rates. Subprime borrowers who had

maintained payments for the first 2-3 years at the lower interest rates, began skipping payments.

But before this had even occurred the Subprime mortgage market collapsed, followed soon after by

the stock market and eventually huge holes began to appear in balance sheets all over the world.

(Geanakoplos, 2009)

How bad was the financial collapse of 2008?

Three of the five largest investment banks in America failed. The country’s largest residential

mortgage funder failed. The country’s fourth largest commercial bank failed. The United States

largest insurance company failed. The great semi-government mortgage assemblers, Fannie Mae and

Freddie Mac failed. Two of the four largest UK banks failed. The largest bank in Belgium, and the

largest bank in Holland. Tens of billions of dollars were lost by banks in Switzerland, France, Russia,

China and Germany. The list goes on. (Fish, 2009, September)

No sector was blamed more than the financial services sector. Not every country’s banking system got

it wrong. The banking systems of Canada, Brazil, Spain and Australia did remain stable. (Fish, 2009,

September) But that is only the regulated side of the whole banking system, as it was in 2008. By the

time of the crisis, the conventional system was competing directly with its nemesis, the ‘shadow’

banking system. (Gorton, 2009) (Krugman, 2009, June 08)

According to Krugman we fell into the illusion that a bank had to be a depository institution and we

had forgotten about things like bank runs.

A bank is not a big marble building with a row of tellers. A bank is any institution, or any

arrangement, that allows people what seems to be ready access to their funds, while at the same

time financing long term and/or illiquid investments. (Krugman, 2009, June 09) 6 The detailed story Geanakoplos tells is that 70% of Subprime borrowers had always been able to re-finance their Subprime mortgage between years 2 to 3, before its interest rate shot up. That is Subprime borrowers were no longer considered the same credit risk, and it meant that lenders for the Subprime loans were assumed of getting back 70% of their money within three years of lending it. In 2007, Subprime borrowers could not re-finance their loans, and it meant that lenders got nothing back either. (Geanakoplos, 2009)

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Krugman points out that in retrospect, a lot of the ‘shadow’ banking system represented an ‘end run’

around conventional banking regulation.

When the crisis hit, far from having a secure banking system, it was more than half as un-regulated, as

un-insured and as un-policed as it had been the case at the beginning of the Great Depression. People

say nowadays, that we haven’t had great waves of bank failures like there was in the 1930s. But in

fact, we have. It is just that they do not look like banks. The shadow banking system today has

suffered a huge shrinkage in volume.

In October 2008, the Federal Reserve bank officials testified before the US congress, in order to pass

through legislation for the ‘Troubled Asset Relief Program’ – telling members of the house of

representatives, that ATM machines would dry up. A flurry of faxes that would go around Wall

Street, and shortly afterwards, the world would all come to an end. If banks were not willing to make

trade credit available, then activity in the economy would stop. (Reinhart V. , 2011)

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W h o i s t o b l a m e ?

Who or what should be apportioned the blame for this catastrophic market failure?

What were central banks doing during the decade of the 2000’s? Central banks stood back and

watched as banks’ hugely expanded their balance sheets. Central banks stood back and watched the

expansion of the parallel ‘shadow’ banking system and as the amount of credit in their economies

grew and grew. (Gorton, 2009) (Alessandri & Haldane, 2009) They stood back and watched the

extreme levels of asset price inflation and household debt accumulation. (Davies & Green, 2010)

Bank leverage in the regulated sector expanded rapidly from 2003 on, as it tried to compete with the

un-regulated parts of the system. (Davies & Green, 2010) Central banks stood back and watched as

risk became seriously mis-priced. The Central banks around the world were writing their financial

stability reviews – which included only half of the recommended IMF indicators of financial

stability.7 (Davies & Green, 2010)

Martin Wolf has said the United States is the one country that can finance itself. It is the country that

issues the reserve currency. That is why it is stable. But Wolf also thinks the system turned out to be

less stable than the experts expected. What ‘broke’, was not the global capital flows, but the domestic

banking system. The US financial system broke under the intermediation process, of trying to sustain

the global capital flows. (Wolf, 2011, March 16)

The conventional wisdom, at the time of the 2008 crash in the financial system, was that Central

banks could not do very much to prevent formation of asset price bubbles. It was best to wait until the

bubble had burst, and try to clean up the mess afterwards. (Davies & Green, 2010) (Soros, 2008)

With its intervention in March 2008, to rescue Bear Stearns, the US Federal Reserve extended the

perimeter of its safety net. The Federal Reserve bank had not lent outside a set of commercial banks in

volume for more than 20 years. It sent out a market signal, for who it was going to support. (Reinhart

V. , 2008)

7 Professor Charles Goodhart has conducted important research in this area. (Goodhart, 2010) The European

Central bank has said in its 2010 review that financial stability needs the sustained intellectual investment that

only price stability has received. (Davies & Green, 2010)

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The play book for government intervention in times of financial crises had been documented, written

about and well-rehearsed during the Clinton administration years of the 1990’s.

Normally, a branch of government would lend money to a leveraged entity in a time of great stress.

The financial assets that the entity held could not be liquidated in sufficient time to pay back short

term liabilities. Government would try to assist those institutions who are supporting lending in the

general economy. Governments were preventing fire sales. (Reinhart V. , 2011)

If you force the financial institution to liquidate it would be selling impaired assets into the market all

at once. Prices would go well down below fundamental value. There would be capital losses, that

wouldn’t be suffered by anyone, if only the assets could be held to their true maturity. We have this

presumption that government intervention is a free lunch. (Reinhart V. , 2008)

The $50 billion Mexican guarantee of credit was never invoked, so it did not cost the taxpayer a cent.

It was a free lunch. But why doesn’t a market speculator simply choose the next institution where the

government will intervene – short sell its equity and buy its unsecured debt?

The fact that government stands ready to help in the resolution of the firm, doesn’t stop the incentive

to speculate in the market. It doesn’t prevent strains in financial markets. It only puts them in different

places. Reinhart argues that if you have provided a blueprint for how you are going to resolve entities

– protecting some portions of the balance sheet, wiping out another portion – that is a blueprint to

speculate against the firm. (Reinhart V. , 2008)

The Federal Reserve bank lent to Bear Stearns to protect unsecured creditors. When unsecured

creditors were saved in the Bear Stearns resolution, the cost of buying insurance for Lehman Brothers

(which had a similar balance sheet of assets to that of Bear Stearns) on the CDS market, went back

down. The US Federal Reserve sent out a message to the world. Unsecured creditors don’t have to be

as careful as they would otherwise be.

After the resolution of Bear Stearns in March 2008, the Federal Reserve then opened its discount

window to the remaining primary dealers, of which Lehmans bank was one of twenty such institutions

in early 2008. It allowed primary dealers to borrow at subsidized rates. At rates that were below what

they could borrow at in the market in early 2008. Hence, these primary dealer institutions received a

form of subsidy.

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The purpose of such an action by the Federal Reserve was to give the primary dealers time to clean up

their balance sheets, so that they could learn a lesson from Bear Stearns. In theory, the financial

system would have become more secure and less vulnerable.

Lehman Brothers bank did not learn the same lesson from Bear Stearns as the Federal Reserve had

hoped. Lehman Brothers bank assembled together all the bits of underwriting that remained on its

balance sheet. A mixture of various mortgage backed securities, collateralized debt obligations.

Lehmans rolled them all up together and issued it as a new security, that was eligible as collateral for

borrowing at the Federal Reserve bank’s recently opened discount window. (Reinhart V. , 2008)

Rather than begin a process of cleaning up its balance sheet, Lehman Brothers embedded the risk even

deeper into its own balance sheet with its new security – a security which had no other customer other

than Lehmans bank itself – because it could only serve as collateral at the Fed discount window.

(Reinhart V. , 2008)

No matter how hard US Secretary of the Treasury, Hank Paulson, worked each weekend in 2008,

there was always another financial firm getting into trouble. In 2008, over and over again, the same

play book was used by the US government with many of the large institutions. Between Bear Stearns

and Lehman Brothers was the resolution of government sponsored enterprises Fannie Mae and

Freddie Mac – with the result that unsecured creditors are again made whole, at 100 cents in the

dollar.

23

Figure 5 - Unconventional Monetary Policies, US Federal Reserve Bank.

Source: United States Federal Reserve bank.

Government intervention was made possible, while avoiding the US House of Representatives, using

government off-balance sheet entities. At a time of crisis, the US Federal Reserve bank itself has

become a government off-balance sheet entity. The Dodd-Frank reform legislation of July 2010

signed into law by president Obama just legitimizes the government’s use of power in those

situations. (Reinhart V. , 2008) (Greenspan, 2011)

When the United States government did ‘let one go’, the world didn’t come to an end because

Lehman Brothers assets were tied up in the courts. The bankruptcy process does work. The collapse

of Lehman Brothers sent the signal it did to the market, because an expectation of government

intervention wasn’t realized. The market players screamed ‘Oh my God! They aren’t going to bail us

out!’ (Reinhart V. , 2008)

According to Reinhart, we might be in much better shape today, if we could do things to make the

bankruptcy process more transparent and easier – than having too many government resolution

processes. (Reinhart V. , 2008)

If Bear Stearns had gone bankrupt in March 2008, the Federal Reserve would have had to provide

funds to support a market, rather than provide funds to support institutions. We witnessed a similar

behavior in Ireland during the late 2000’s. The Irish government tried to maintain such things the

National Asset Management Agency as an off-balance sheet entity, without success.

24

“It is not the taxpayer that is putting money into it (NAMA). The taxpayer will gain money from

it (NAMA). We will get back liquidity into the banking system which is causing the absolute

disaster that we have in the economy right now”.

“The payment for these loans will not come from the taxpayer. It will come from the issuing of

government bonds, which will then be cashed by the banks at the ECB. It is really the ECB

which is putting this money in”. (Fahey, 2009)

It should not be surprising, given that consultants such as Goldman Sachs sell the Clinton ‘play book’

around the world, to whatever government is experiencing a national crisis and can come up with the

fee.

25

W h a t i s E u r o z o n e ?

The Eurozone is a fixed exchange rate system in operation between a number of separate sovereign

European states. Dissimilar to the United States federal system, the Eurozone is an economic union,

without a political union. Critics understand that to be one of its shortcomings. There are efforts

underway as this study is being written in early 2012 to extend the degree to which fiscal policy

decisions are centralized for all Eurozone member states. (Whelan, 2012)

From an Irish industry and investment point of view, the added cost to business from having to hedge

against exchange rate risk, had made Ireland un-competitive relative to other countries with stable

currencies. 1992 saw an orchestrated market raid on the British pound – a highly leveraged bet that

the British currency was over-valued. The bet had paid off for the speculators, when the British pound

had to de-value.

“It (Confederation of Irish Industry in a request in 1979) sought that Government underwrite

the exchange risk for industry, and pointed out that the cost to the Exchequer would be zero, if

the Irish currency maintained its value against EMS currencies, in accordance with Government

policy”. (Power, 2009)

Currency exchange rates are extremely important for a small open economy where exports and

imports, combined, significantly exceeded GDP in value. (Power, 2009) In March 1979 when Ireland

had first joined the European Monetary System, or EMS, the Irish Pound broke its one-for-one parity

with Sterling, which had obtained since the Act of Union in 1801. That early EMS, proved to be a

zone of monetary stability in a world where major currencies fluctuated violently, (Power, 2009).

Ireland was eager to increase its monetary integration with the rest of Europe – and gain more access

to a large market for its produce.

The first of several stages for full European monetary union began in 1990. Later stages of monetary

integration were scheduled to occur between 1994 and 1997. (Power, 2009)

For the full European monetary union to take place, at least seven European community member

states were expected to meet pre-designated criteria. For eligibility for full membership of the EMU,

Ireland was expected to achieve a high degree of price-stability, in terms of inflation being close to

that of the best-performing Member States. The second major consideration for Ireland pre-2002 was

26

a requirement to have a sustainable Government financial position. Ireland passed eligibility tests on

both accounts and became part of the Eurozone in 2002. (Power, 2009)

The Eurozone system operated for ten years since 2002, as though all member states had exactly the

same credit risk. But in 2010 especially, the market realized that fiscal positions of EU countries

would deteriorate dramatically, because of what happened in the private sector of those member

states. (Wolf, 2010)

The Eurozone saw a massive explosion in debt spreads of some countries over Germany’s interest

rates. Ireland, Greece and other countries became completely illiquid, and dependent on sovereign

bailouts from their partners. (Wolf, 2010)

27

T h e E u r o z o n e a n d E u r o p e a n o r

I n t e r n a t i o n a l P o l i c y M a k i n g .

What policy options are available to European and International Policy makers to

restore stabil i ty to the Eurozone?

Europe had neither net capital in-flow or out-flow. But Europe replicated within itself, the imbalances

we saw at the global level. (Krugman, 2009, June 09)

Wolf believes that Germany is being driven painfully to financing the deficit countries in the

Eurozone, because otherwise it has to write off its assets. (Wolf, 2010) The Eurozone system is

struggling towards working in the way that John Maynard Keynes (an important contributor at the

Bretton Woods conference in 1944), thought the global financial system should work. (Wolf, 2010)

(Chwieroth, 2008)

I will describe some policy options and challenges faced by European and international policy

makers, in relation to the Eurozone crisis, by viewing measures which were employed in the United

States of America recently.8 Coming up with policy actions to deal with the first wave of the

Eurozone crisis is one thing. The pertinent question is asked by Nouriel Roubini – is what happens

after a double-dip recession? (Roubini, 2010, May 18)

The United States committed something like $11 trillion of resources to the financial system, post the

2008 crisis – of which three out of the eleven trillion were spent. (Roubini, 2010, May 18)

The resources were committed via numerous policy avenues, including an $800 billion fiscal stimulus

and the running of a fiscal deficit of 10% of GDP. The US Federal Reserve bank has bought $1.8

trillion between Treasury bonds, and agencies such as Freddie Mac and Fannie Mae. There were

government guarantees extended, re-capitalization of financial institutions, interest rates were pushed

8 In a recent article in the Irish Times newspaper by Karl Whelan (Whelan, 2012), he builds on ideas as

expressed by economist Paul Krugman, in relation to deficit spending by government, in order to reduce the

extent to which we impoverish ourselves in the future.

28

down to zero, quantitative easing was undertaken and doubling of base money. (Roubini, 2010, May

18)

But if we end up in a double-dip recession, having extended the level of government support to the

financial system extended thus far, we are running out of ‘policy bullets’. (Roubini, 2010, May 18)

Governments cannot quadruple the monetary base – or you end up with hyper-inflation. There is no

sense in trying to double a budget deficit of 10%, to make it 20% of GDP – with public debt

exploding from 100% to 200% of GDP. The markets are already worried about government’s ability

to pay.

If there is a double-dip recession, then governments cannot do much to backstop the financial system.

The United States has already guaranteed $11 trillion of assets, and another round is simply not

possible. How can a government guarantee a financial system, when it is deemed insolvent itself? The

guarantee will mean nothing. (Roubini, 2010, May 18)

If the governments remove the fiscal stimulus too fast, when recovery in the economy is weak and

tentative, then you end up back in recession. If governments leave the fiscal stimulus, or monetize the

public debt, it creates inflation, which in the long term is going to push interest rates higher. Thereby a

recovery is crowded out, owing to lack of finance. Roubini uses the phrase, ‘damned if you do and

damned if you don’t’, to describe the predicament. (Roubini, 2010, May 18)

Roubini who has studied crises for decades, commented on the fact, the balance sheet problems that

are associated with today’s asset price bubbles, are not typical of the old business cycle. Roubini talks

about long cycles today, where elements of one crisis merge into another one.

Nowadays, fall-out from crises which produce losses in the trillions of dollars, or between 10-30% of

GDP are no longer the exception. (Roubini, 2010, May 18) What US Federal Reserve Chairman Ben

S. Bernanke referred to as the ‘Great Moderation’ (Bernanke, 2004), has actually led to more

instability in the financial system.

The fact is, we have no clue, as to what the Eurozone financial clean-up process could end up costing

– If one compares it to the situation as seen in the United States economy. Roubini cites the ex. US

Federal Reserve Chairman Paul Volcker as stating we need more radical reform – because the huge

cost of banking crises has led to too high a fiscal cost. (Roubini, 2010, May 18)

29

Central bankers such as Ben Bernanke believe it is impossible to identify bubbles and asset price

misalignments. But others, (Davies & Green, 2010) have asked: if you cannot identify bubbles and

misalignments with certainty, is it any harder than the other judgments that one has to make – such as

determining the output gap, when determining short-term interest rates. The cost of not doing

anything about bubbles and misalignments, can be very large indeed.

The BIS economist, Bill White’s view (White, 2006), is that monetary policy should be more focused

on pre-emptive tightening to moderate credit bubbles, than on pre-emptive easing to deal with the

after effects.9

Crisis followed by reforms, is that which leads to the continued evolution of financial regulation.

(Soros, 2008) A central bank needs a robust set of indicators of stress and we need to put credit back

into macro-economics in a meaningful way. (Davies & Green, 2010)

Monetarism is a false doctrine. Controlling interest rates only is not enough. Credit and money do not

go hand in hand. Independently of money supply, you can have an overall credit contraction in the

economy, or a credit expansion. You must regulate credit as well as money. (Soros, 2008) Regulators

say they do not have enough instruments, and they are correct. It used to be the case years ago, that

margin requirements on stocks were adjusted up or down, depending on market levels.10 (Soros,

2008)

A central bank needs to patrol the regulatory frontier. That is the big lesson of the current financial

and economic crisis. (Davies & Green, 2010) Things were going on outside the regulated universe,

that central bankers were not interested in – they ought to have been. Davis and Green (Davies &

Green, 2010) believe that central banks ought to contribute to the assessment of the need for counter

cyclical policy requirements, or macro-prudential regulation.

According to (Davies & Green, 2010), the key factor in implementing new tools like macro-prudential

regulation, is to carefully engineer how they will interact with interest rate policy adjustment. If you

use capital regulation based on a concern for the overall amount of credit in an economy (and the

9 That is, there may be occasions when you would be seeking to tighten policy even when your short term

inflation objective was being met. (White, 2006)

10 The length of this document did not allow for a detailed examination of the ‘Leverage Cycle’ theory of John Geanakoplos, professor at Yale University. But in common with Soros and others would advocate intervention by the Central banks to regulate ‘credit’ in the economy as opposed to just interest rates – Geanakoplos, believes very strongly the Federal Reserve bank in the US – ought to gather data about degrees of leverage within the economy. Something that the Federal Reserve has never done to date. (Geanakoplos, 2010 August)

30

asset price bubbles related to that), what you are achieving, is alteration of the price of credit. It will

not mean anything unless private banks respond to an increase in their capital requirements by

increasing their own lending interest rates to their customers.

Therefore, macro-prudential regulation ought be considered alongside monetary policy – and not

separately – as per the old ‘one instrument, one target’ approach.

Further analysis of the limitations of conventional monetary policy are provided by the economist

Paul Krugman, who admitted he believed until 1997, in the overwhelming effectiveness of monetary

policy and in the wisdom of Central bankers like Alan Greenspan. (Krugman, 2009, June 08)

“Whoever was in control of the money supply, could always reflate demand”.

(Krugman, 2009, June 08)

Economic experts believed that really big falls in demand were not going to happen. World industrial

output following the shock of 2008, has fallen every bit as fast as it did during the Great Depression.

(O'Rouke & Eichengreen, 2009) Paul Krugman observes that we were supposed to have this kind of

thing under control. They only thing that had caused Krugman to harbor doubts, (demand shocks that

policy makers could not control) was the case of Japan.

Following the crash in Japan, monetary policy had been pushed to its limit where the interest rate on

short-term government debt was zero. Nonetheless, the recession persisted.

“Japan very nearly doubled the monetary base, and it did nothing – it had no effect

whatsoever”. (Krugman, 2009, June 08)

Krugman began to ask himself the question, could this happen in the United States as well? Krugman

looked at the history of economics in the United States, and in particular at the Great Depression era.

The US Federal Reserve bank in the 1930’s had expanded base money supply, but it had just sat there.

Krugman’s description of this problem is what he calls the ‘Liquidity Trap’.

According to Krugman, if you are in a liquidity trap as central banks in developed nations find

themselves in today, the interest rate that one would need to enable full employment, is unfortunately

negative.

31

“But it turns out, a non-inflationary economy, is one in which booms really get out of hand –

and in which interest rates are low in general – leaving less room to cut”. (Krugman, 2009,

June 10)

You cannot set the interest rate below zero, or else people buy cash instead of government issued

Treasury notes. We have reached the lower bound limit of conventional monetary policy.

“Today a recession means that inflation slips and heads towards deflation. If people expect

prices to fall, or expect prices to rise less rapidly, it makes them less lightly to borrow”.

There is a lot of excess capacity in the economy. Why build new factories and shopping malls, if you

cannot use the ones that you already have? We are in a world where expanding government deficits,

does help saving. The government deficit is giving those savings some place to go.

What happened in Japan of the 1990’s, is now a problem for all of us. It would be helpful if we could

get some inflation – not so much to inflate away our debt – but to bring down the real interest rates.

Figure 6 - Explosion of fiscal deficits as a percentage of GDP.

Source: Martin Wolf. (Wolf, 2011, March 16)

Krugman believes that the monetary policy as pursued by central banks such as the US Federal

Reserve in today’s world, is anything but conventional. Federal Reserve chairman Ben Bernanke has

overseen the purchase of a lot more than short-term Treasury paper – tripling the size of the Federal

32

Reserve bank’s balance sheet (Refer to Figure 5 - Unconventional Monetary Policies, US Federal

Reserve Bank in this document).

Krugman describes this new activity by the Federal Reserve, as doing the lending that private banks

are not willing to do – and serving as the financial intermediary of last resort. However, all of this

activity while expanding the monetary based is having no inflationary effect in the real economy. The

banks are just sitting on too much excess reserve. (Krugman, 2009, June 10)

33

S t u d y o f I r i s h E c o n o m i c s

T h e I r i s h B u b b l e .

Figure 7 – Skyline of Dublin Docklands Area in 2000's.

Source: Irish Times Newspaper

Is i t correct to describe the IRISH residential and commercial property markets

behaviour between 2001 and 2008 as symptomatic of a market experiencing a

‘bubble’?

John Fitzgerald wrote (Fitzgerald, 2009):

“While the most obvious fall-out from the burst bubble is the collection of severely damaged

Irish banks, a more serious long term problem is the loss of competitiveness caused by the

building boom. To get the resources the building sector needed during its period of excess, it

had to rob resources from elsewhere in the economy. This was done by bidding up prices, wages

and costs”.

The following quotation from economist Paul Krugman could describe the Ireland of the second

phase of the Celtic Tiger.

34

“The US economy has become a place, where we make a living, by selling each other houses,

which we pay for with money we borrow from the Chinese, and this is not going to end well”.

(Krugman, 2005)

In the initial stages of the so-called Celtic Tiger, Ireland had found itself on a quite sustainable path

towards growth and full employment.11 The years following Ireland’s adoption of the new Euro

currency are the years in which the most devastating damage was done to Ireland’s economic miracle.

Figure 8 - Monthly house completions, based on ESB electricity connections.

Source: Department of Housing, Heritage and Local Government.

The misconception in real estate being that the price is independent from the willingness to lend.

(Soros, 2008) (Kelly, 2009)

11 The length of this paper does not allow me to analyse the period of Ireland’s growth directly leading up to the so-called Celtic Tiger. The period of the late 1980s and up to the mid 1990’s decade, saw a fiscal surplus for the Irish government for the first time in many decades, and the beginning of payment its national debt. Refer to the 2009 published work of Con Power, former economic advisor at the Confederation of Irish Industry, CII, and Irish Business and Employers Confederation, IBEC, for further information. (Power, 2009)

35

Figure 9 - Property lending in billions of 2009 Euro, 1993-2009.

Source: Morgan Kelly. (Kelly, 2009)

According to Krugman and many other economists, the thing that happened in parallel with the

expansion of the banking system, was the rise in leverage throughout the economy – not by corporates

– but by households. (Krugman, 2009, June 09) The requirement to put up collateral for borrowing

became drastically reduced, as a direct result of financial de-regulation.12 By the time of the ‘Savings

and Loan’ crisis of 1982, in the United States, the last of the ‘New Deal’ 1930’s era regulations were

dis-mantled.

Where expansion of credit to the household sector is concerned – the flip side of that coin, was the

sudden collapse of private sector borrowing following 2008. Savings which had almost dropped to

zero, suddenly shot upwards. Irish economist at the Economic and Social Research institute, John

Fitzgerald wrote.

“One of the reasons why this economy will lag behind the rest of the Euro area next year is the

huge uncertainty affecting households and companies in Ireland. Until individuals feel

reasonably certain about their jobs and future incomes, it is very difficult to see them deciding

to increase their consumption, buy a new car or invest in a house”. (Fitzgerald, 2009)

12 If space had permitted a key part of my analysis ought to include the work of Yale economist John Geanakoplos, and his theory of the ‘Leverage Cycle’. (Geanakoplos, 2010 August)

36

The Irish economy in the 2000’s decade, had tried to re-organize itself around the new arrival of flows

from other EU countries. When this flow of credit was turned off post 2008, the Irish economy had to

re-adapt all over again. Paul Krugman puts it neatly in the following quotation.

“What we have had since the mid-1980s is long booms that never had too much inflation – that

basically collapse underneath their own weight”. (Krugman, 2009, June 09)

37

T h e I r i s h B u b b l e a n d i t s U n d e r l y i n g

F a c t o r s .

What were the underlying factors which led to the Irish residential and property

markets performance between 2001 and 2008?

The main factor is to do with the Irish banking system, and how it imported so much capital from

abroad into the Irish economy.

“When Bank of Ireland Scotland offered mortgages of 100%, no one stood up and shouted stop!

We don’t need it! (Fahey, 2009)

There is also the matter of government tax spending, otherwise known as tax relief schemes for

property buyers. Commentators have referred to tax breaks for property as the ‘fuel the Irish

government threw on the fire’.

The Irish government and the opposition, rejected Dr. Peter Bacon’s recommendations in his

reports in late 1990’s, for the introduction of a property tax”. (Fahey, 2009)

At an annual economics conference at Kenmare in 2010, Dr Micheál L Collins, an economist at TCD,

and Mary Walsh, a chartered accountant told that in decisions on where to focus tax expenditures, or

tax relief schemes, there was “very limited economic evaluation”. (O'Brien, 2010)

“When compared to seven OECD countries included in a recent OECD study, the authors note

the use of tax breaks and incentives is not unusual in Ireland in terms of overall tax revenue

foregone. What is unusual is that the cost of the tax breaks is concentrated in a small number of

reliefs”. (O'Brien, 2010)

38

The reasoning behind the massive expansion of credit into the Irish economy post 2003, has never

been adequately investigated. In Ireland in 2012, we are more aware of the consequences of such

actions. Between 2003 and 2007, Irish banks increased their net borrowing from abroad by an

astonishing 50% of annual GDP. (Honohan, 2008, December 02) According to Honohan, even

Icelandic banks did not import funds on that scale.

Figure 10 - Evolution of credit in Irish economy, Y-axis shown as millions of euro.

Source: Central Bank of Ireland, Money and Banking Statistics.

Honohan recalled that funding of such loans from abroad by the Irish banking system, would not have

been so effortless in the past. Such high levels of foreign borrowing left the Irish banks very

vulnerable. By September 2008, at least one of them could not roll over the loans, was the trigger for

the infamous Irish bank guarantee. (Honohan, 2008, December 02)

“When Irish banks increased credit to the Irish economy from €160 billion at the beginning of

2003 to €380 billion at the beginning of 2007, no one shouted: Hey, the banks shouldn’t be

giving out so much money. Allied Irish bank increased its lending to €83 billion on property,

which is 62% of its total loan book”. (Fahey, 2009)

39

Figure 11 - Average first time buyer mortgage and new house prices, relative to average earnings.

Source: Morgan Kelly. (Kelly, 2009)

Exactly as has happened on the global financial system level - when the capital stopped flowing

within the Eurozone system – there was a massive collapse in private sector spending – particular in

the case of Ireland and Spain. (Wolf, 2010)

The Eurozone did replicate the imbalances that were seen at the global economic level. Germany in

particular, and Holland became gigantic capital exporters. Spain and the United Kingdom became the

largest capital importers in the region. Lending to eastern European countries, though quantitatively

speaking was not very large – relative to the size of some eastern European economies – the inflow of

capital was enormous and resulted in huge bubbles being created. (Krugman, 2009, June 10)

“By the numbers, it was a complete re-production of what had happened in South East Asia”.

“Look at Latvia in the 2000’s. That is Thailand”. (Krugman, 2009, June 10)

Krugman can relate what happened to the ‘Asian Tiger’ economies in the late 1990’s, to what also

occurred in the 2000’s with the Baltic and eastern European states. (Krugman, 2009, June 09)

Deficits in Italy and France are large, but less important, relative to the size of those large economies.

Spain was the dominant deficit country in scale and it played a role similar to that of the US at the

global scale. (Wolf, 2011, March 16)

40

The Eurozone crisis is like the global financial crisis in miniature – with one key difference – the

fixed exchange rate system of the Eurozone changes the way in which the adjustment process can take

place. (Wolf, 2010) There was far too much lending and borrowing within the Eurozone system. It

needs to re-balance itself. But the question is how can it do so?

It is worth taking a look at what did occur at a global level – because in looking at that problem – we

may gain some understanding of what happened ‘in miniature’ within the Eurozone itself.

Wolf (Wolf, 2010) places particular focus on the change in the global monetary regime, towards

currency reserve accumulation in emerging countries on an unprecedented scale. In a floating

currency world, Wolf and others had believed, there would be no need for foreign currency reserve

accumulation and that countries would not bother. That prediction turned out to be woefully incorrect.

(Wolf, 2010)

Historically speaking, it was rich countries that had more capital than they could use, and exported it

to poorer countries. Contrary to that norm, the exact opposite happened in the decade of the 2000’s.

Exports of capital in the form of foreign currency reserve accumulation by emerging countries has

climbed from $1.5 trillion in the late 1990’s to $9 trillion by the time of the 2008 financial crisis. It

has risen by almost $2 trillion more since the end of the crisis. That is $9 trillion to manage the

exchange rate system, and to ensure that capital is being recycled abroad. (Wolf, 2010)

Figure 12 - Surplus capital exporting countries.

Source: Paul Krugman. (Krugman, 2009, June 10)

China today combines twin roles of the world’s fastest growing country and the world’s greatest

exporter of capital. Those were roles carried out separately by Great Britain and north America at the

41

end of the nineteenth century. China’s reserves have gone from $100 billion in the late 1990’s to $3

trillion, which is around 50% of China’s GDP. (Wolf, 2011, March 16)

Net capital exports from China peaked at 10% of GDP, at a point when investments had also reached

40% of GDP – the total savings of China had reached an outstanding 50% of GDP. The amount of

capital exported by China was equivalent to the amount for Japan and Germany combined together.

At peak, surpluses of China and the rest of Asia, rose to over 3% of total world GDP. From 1997

onward, the United States imported capital on a gigantic scale, absorbing 70% of that surplus. (Wolf,

2011, March 16)

Figure 13 - Foreign currency intervention: global currency reserves.

Source: Martin Wolf. (Wolf, 2011, March 16)

Normally in countries where you import a lot of capital, you would expect it is the business sector

doing it. But the problem was, the richest countries had no idea what to do with this net in-flow of

capital from emerging countries. They failed to use it in any useful way. It went into household

consumption. The graph by David Harvey, shows how debt service payments have risen against

disposable income of those working in the United States between 1980 and 2006.

42

Figure 14 - Consumer debt service ratio.

Source: Board of Governors, Federal Reserve Board, Household Debt Services and Financial Obligations Ratios

From 2008, the household sector in developed countries, suddenly began to accumulate savings,

leaving a huge gap in demand for goods and services in countries such as the UK and United States.

Government since 2008 have been operating fiscal policy designed to try and combat the collapse in

spending by the household sector. Wolf (Wolf, 2010) said that we have not seen this kind of deficit

spending by governments since the Second World War.

The really big global macro-economic question in view of Wolf (Wolf, 2011, March 16), is how the

re-balancing process will work. The crisis has left some very important high income countries with

damaged financial systems, dramatically over leveraged household sectors and very large fiscal

deficits. The reason that developing countries accumulated $10 trillion of foreign currency reserves, is

that they do not trust themselves in a situation where they might be forced to borrowed from the

International Monetary Fund. They do not trust the insurance arrangements. They want to self-insure,

on a massive scale.

Advanced countries are no longer in a condition to absorb net exporting of capital from emerging

economies. Wolf believes that at some stage governments in emerging countries will come under

political pressure from citizens, to run a fiscal deficit. Wolf believes that when that occurs it will

finally help to re-balance the global financial system and alleviate our current crisis. (Wolf, 2010)

The United States should lead an international effort to stabilize the system, which includes the

peripheral economies. Hopefully China will be more a part of the global financial system. The United

States dominance over the global financial system will not last. (Soros, 2008)

43

At the much hyped ‘Irish Property Developers conference’ in Dublin in 2007, the presentations all

focused on a notion that a small band of leveraged Irish borrowers could storm into eastern Europe

and swipe the profits from under the noses of Baltic and former Communist block states. That

excursion was to be funded by the Irish banks such as the former ‘Anglo Irish’ bank.13 Irish banks

began to acquire banks in eastern European countries, in anticipation of this Irish (and very ill-fated),

version of ‘Operation Barbarossa’.14

Of course, the Irish banks that were to fund such an economic and property building experiment did

not have funding of their own. They had to borrow it from capital exporting countries such as

Germany. It brings this analysis back to the point made by Professor Harvey: the manner in which the

modern financial system is able to move capital around the globe, using all kinds of intermediaries,

principals, agents and so forth.15 (Harvey, 2010)

Ireland, in the opinion of this study does not have sufficient regulatory systems in place, financial

oversight by its Central bank, or indeed the level of market sophistication that is required to undertake

the voyages it had tried to organize. The brief domination of global trade by the Dutch in the late

1600’s serve as the kind of analogy one may look for, in trying to understand why such a small nation

such as Ireland would try to command the global property development industry.16 17 (Bernstein,

2008)

13 Anglo Irish bank is infamous today in 2012, because it ended up costing the Irish taxpayer billions of euro, just to wind it down and make it disappear. It’s shareholders in Ireland pre-2008 included some of the wealthiest ‘movers and shakers’ in every small town and parish in the whole island. A lot of sensible, old wealth was lost, when Anglo Irish bank had be nationalised by the Irish government in early 2009. 14 Based upon personal recollection of the author and extensive involvement with the Irish property development industry at the time in question. 15 The length of this paper did not allow for detailed explanation, but I will draw attention to the work of Dr. Paul Woolley of the London School of Economics, who has published some work about the problems associated with dis-intermediated Principals and Agents in the more financial system. (Biais, Rochet, & Woolley, 2010) On a similar subject matter to that of Dr. Paul Woolley – the work and teachings of Ira Millstein, or so-called ‘Dean of Corporate Governance’, and professor at the Yale School of Management, is noteworthy of reading also I believe. (Millstein, 2011) 16 One of the reasons frequently cited for the long dominance of the British over global trade and its general success in establishment of remote colonies, was that it financial system at home, had been so well managed and robust. In contrast, the Portuguese financial backup during its brief period as a global power was so under developed, that trading vessels often had no money to buy goods when they arrived to their destinations. That too is quite similar to the Irish property developers in the early 21st century. 17 The length of this study does not allow for examination of the case of Iceland and its banking system during the 2000’s. Iceland was a country of only about 300,000 inhabitants, yet it had a banking system far, far larger than the size of its domestic economy, which revolves mainly around fishing.

44

T h e I r i s h E c o n o m y a n d E u r o z o n e c r i s i s .

Figure 15 - Portugal, Ireland, Greece and Spain.

What are the potential implications for the Irish Economy of a severe escalation in

the crisis of the Eurozone?

Power (Power, 2009) provides a quotation from ‘The Economist’ journal from 1986, which he felt

gave a very simple and pragmatic message to illustrate a relationship between the money economy

and the real economy.

“Of all the ways for poor countries to become less poor, one stands out: Make sure exchange

rates reflect internal-versus-international costs, so that exporters are not squeezed while

(others make) a fortune importing shoes and ships and sealing wax at what, in local currency,

are dirt-cheap prices.”

Professor Honohan observed that Euro membership, created a low interest rate environment in which

the Irish economy operated from 1998 onwards. (Honohan, 2010, May 31) That interest rate reduction

helped to trigger a demand for purchase of new homes.

45

Figure 16 - Housing Investment as a percentage of GDP.

Source: John Fitzgerald, ESRI.

John Fitzgerald wrote (Fitzgerald, 2009):

“To return the economy to full employment in the next decade, a substitute will have to be found

for the unsustainable jobs lost in building. These new jobs will have to be created by firms

developing and expanding into new markets abroad. However, as of today, this is a very

difficult task given Ireland's very high cost base”.

The potential implications for Ireland of an escalating Eurozone crisis are complex. But first among

the concerns in 2012 is the support Ireland is receiving from the ECB for its broken domestic banking

system. It is several years after the peak of the 2008 crisis. Ireland has made little progress in

returning to sustainable growth despite the deficits spending by government, and the level of support

offered from the EU and IMF.

Figure 17 - General Government Balance, as per cent of GDP.

Source: IMF, WEO, April 2010.

46

John Fitzgerald wrote (Fitzgerald, 2009):

“If the awful unemployment problem is to be solved by the middle of the next decade through

nurturing new jobs, Ireland will have to price itself back into its European markets. This could

be done by holding wage rates unchanged for quite a number of years as wages rise slowly in

our competitors. Such an approach would eventually work but competitiveness would only

gradually be regained”.

Figure 18 - Lost competitiveness in periphery, Unit Labour costs, relative to Germany.

Source: Martin Wolf. (Wolf, 2011, March 16)

During the boom period, there were massive increases in unit labour costs relative to Germany.

Competitiveness that has been lost now has to be re-gained, because the only way out of Ireland’s

crisis is through investment and exports. But if Ireland deflates in this way, the real level of debt gets

higher and higher. (Wolf, 2011, March 16)

Figure 19 - Ireland’s projected Debt to GDP ratio.

47

Source: John Fitzgerald, ESRI.

The challenge as described by Honohan is to re-engineer the re-balancing process, with a minimum of

disruption to production and employment. (Honohan, 2008, December 02) Without the support of

European partners, then a small country such as Ireland would not be able to offer the scale of

assistance it did to its private banking system.

“It (NAMA) will not have any effect on property prices. It is the ECB who are putting money

into the Irish economy. Whereas the British exchequer and American exchequer can print money

to put into the economy – we are getting it through the ECB”. (Fahey, 2009)

The complex financial mechanics of the NAMA were also explained to the public on live radio

broadcast, by former Fianna Fail deputy and chairman of the parliamentary Finance Committee Mr.

Frank Fahey, of Galway west constituency. He was speaking at the time that NAMA legislation was

being drafted up in Ireland’s Department of Finance with the NTMA. (Fahey, 2009)

“The ECB is lending this money to NAMA at one and a half percent interest rate, which is a

very low interest rate. NAMA will pay back that interest, from the interest that it gains from the

loans that it is taking over”.

“When NAMA over the next ten years, disposes of these properties, the loans will then be paid

back to the ECB”. (Fahey, 2009)

An idea of economic policy options and conditions – in an absence of Eurozone support – can be

gained from a recent work published by Con Power, a member of the Confederation of Irish Industry

from 1979-1993. (Power, 2009)

“The National debt as a percentage of SNP rose to 85.7% in 1981 and peaked at 117.6% in

1987, amounting to €38,200 million, of which 41% had been borrowed abroad. Servicing the

National Debt consumed 25.4% of net government current expenditure in 1987, or 32.6% of

total tax revenue”. (Power, 2009)

48

“From 1960 to 1992, Ireland’s unemployment rate was almost double the EEC average, despite

significant transfers from the EEC under the CAP and from the Structural Funds, the relative

success in attracting FDI, and the accumulation of an enormous National Debt”. (Power, 2009)

49

S t u d y o n N A M A

N A M A ’ s r o l e .

What is the role of The National Assets Management Agency ( NAMA) ?

The upward re-assessment of risk means that the ratios of debt to equity in the world is now much too

high, and current financing arrangements are too fragile to be supported. Governments around the

world have begun to purchase equity in banks on a large scale, and also to provide backstop

guarantees on large blocks of loans – thereby reducing the banks’ need for capital. (Honohan, 2008,

December 02)

“We need to put serious numbers of billions into the banks between now and Christmas, and

that will start the recovery”. (Fahey, 2009)

NAMA as designed by Peter Bacon in early 2009 (Bacon, 2009), is what is known as a ‘bad bank’, or

a toxic asset vault. It is part of a strategy used by governments in bank resolution schemes in which

illiquid loans on the balance sheet of one or more distressed financial institutions are warehoused until

they reach full maturity, as was originally intended to happen. (Bacon, 2009)

“We had Bo Lundgren (ex. Swedish minister for finance), over to speak to us at the Finance

committee and he explained to us, why NAMA is going to work”. (Fahey, 2009)

Sweden experienced a property market crash and consequent banking system collapse in the early

1990’s. Economists often draw parallels between the ‘bad bank’ solution which was deemed to be

successful in the Swedish case, and the current NAMA solution in operation Ireland today. Deputy

Frank Fahey was anxious to point out also, that Sweden did not have the advantage of European

Central Bank support, when it went through its crisis. (Fahey, 2009)

50

In the aftermath of a substantial financial crisis, bank institutions may be inclined to admit losses only

gradually over time. The economy which depends upon those same private banks for supply of credit,

may find itself starved .

Therefore the creation of NAMA supervised by the National Treasury Management Agency, NTMA,

was deemed necessary to enable the clean-up process of the five Irish banks by the state to proceed.

“They (the Irish banks) would say, leave us alone, and we will work it out ourselves, over ten

years”. (Aherne, 2009)

According to economist Alan Aherne, NAMA should force the Irish banks to accept their losses

quickly – to make them crystallize those losses – and resume with business, even though it may put a

hole in the bank’s balance sheet.

NAMA is being used in Ireland to reduce the size of the balance sheets of the five largest lending

institutions. Half of which are in the process of being wound down and remaining assets sold off. Two

of the banks are to continue on, with a cleaned up balance sheet, re-capitalization and new

management. They are to be restored to what former Finance Minister Brian Lenihan referred to as

‘greatness’. (Lenihan, 2010)

Figure 20 - The Five Irish Lending Institutions.

Source: Draft NAMA Business Plan (13 Oct 2009)

When NAMA was announced in April 2009, and legislation was later being passed through the Irish

Parliament in October of 2009, politicians and citizens may have viewed NAMA as a means by which

to re-create the pre-2008 economic conditions.

51

“NAMA is going to sort out the problems of the banks, and the problems of the property

downturn”. (Fahey, 2009)

Economics advisor to Minister for Finance Brian Lenihan, economist Alan Aherne, explained some

technical details about NAMA. (Aherne, 2009) He drew distinctions between investment properties,

un-completely or abandoned projects, works-in-progress, and purely speculative purchases of

peripheral or un-zoned land for future development. The very ‘mixed bag’ of loans that were being

transferred into NAMA.

Figure 21 - Loan book by loan type.

Source: Draft NAMA Business Plan (13 Oct 2009)

Investment properties are properties which are completed, occupied and functional. In other words,

they generate an income stream – when they were purchased by Irish borrowers (sometimes at what

were known as ‘Paddy prices’). (Aherne, 2009)

Aherne emphasized that where valuation of the loans are concerned a large amount of information is

needed. You have to know who was the borrower. You have to know, what was the collateral. You

have to know when the properties were bought.

“People are assuming that everything was bought at the peak. A lot of stuff was bought in 2004,

2005. There are land banks that were bought back in the mid 1990’s. Those things were bought

for a schilling”. (Aherne, 2009)

If one supposed that in 2009, property prices had fallen by 50%, to roughly where prices had been in

Ireland in 2002 – if NAMA was to purchase a loan associated with a property acquired in 2002 using

a loan of say €10 million - that loan would still be worth €10 million in 2009. (Aherne, 2009) Aherne

believed for a third of the commercial property loan book (€30 billion of the €90 billion), the book

value for investment property loans, could be quite close to a realistic 2009 valuation. (Aherne, 2009)

52

“Wait until next Wednesday week (16th September 2009). You will see, that in actual fact that

the amount of money that is being paid - while it will have a very slight upturn in my view – it

will have a very realistic and prudent price.

All this talk about paying way over the odds, is a load of old . . . .” (Fahey, 2009)

If one can judge anything about priorities of national government in late 2009 from the media and

political discourse – the priority was to fix the property market immediately – and to worry about

fixing the economy later.

Fahey: If you allow the assets, which are pulling down the two main banks at the moment, not to

be able to be, in some way dealt with – what you are doing is, you are bringing the banking

system to a halt. (Fahey, 2009)

Journalist Eamon Dunphy responded to Deputy Fahey as follows.

“The banking system brought itself to a halt. 98% of the people in this country only need a bank

for normal activities. Small businesses, personal loans, stuff like that. These banks destroyed

themselves, and nobody destroyed them”. (Fahey, 2009)

If the property industry in Ireland had become the engine of its economic growth during the decade of

the 2000’s, (Kelly, 2009) then the property industry was to become the engine of recovery in 2009.

The biggest danger perceived by the Fianna Fail government in 2009 was a total collapse of the Irish

property market which may drown out any prospect of recovery.

“It you let all of the property out on the market at the moment, through liquidations, it will be

very hard to sell anything. There will be no liquidity there to buy that property.

If you allow NAMA to take away all of these toxic assets, and store them, the market will begin

to operate again. There is great value out there now, once people have the confidence to start

buying”. (Fahey, 2009)

NAMA was the Irish government’s way of coming to the rescue, of playing the white knight in armor.

NAMA was going to be a ‘free lunch’ for the Irish taxpayer too.

53

“This is being done under an EU framework. What long term economic value means, is that it’s

the money that NAMA will have to get back from those loans, when they sell them off. If NAMA

doesn’t get it back, there will be a levy on the banks to ensure that the taxpayer doesn’t pick up

the bill”. (Fahey, 2009)

Deputy Fahey exchanged these remarks with famous Irish journalist, Mr. Eamon Dunphy on

Newstalk 106 Lunchtime radio program in September 2009.18

Deputy Fahey: NAMA is going to put billions into the banks.

Dunphy, Journalist: But they are our billions.

Deputy Fahey: They are not! (Fahey, 2009)

When deputy Fahey was asked in September 2009, if one could get liquidity going again (in the Irish

economy), without doing NAMA – deputy Fahey’s reply was an emphatic: No you can’t! (Fahey,

2009)

Professor Patrick Honohan speaking in 2008 (now appointed as the Governor of the Irish Central

Bank), about the Irish financial crisis, commented that the Korean and Malaysian economies

experienced V-shaped crashes in 1997/98. Other Asian economies did not recover quickly, because

their banks, though re-capitalized remained nervous and risk adverse. The Mexican economy

experienced a decade of under-lending from its banks after the so-called Tequila crisis of 1994.

(Honohan, 2008, December 02)

Professor Honohan ended his lecture by commenting:

“We wish the banks had not lent recklessly to property, but now we do not wish them to freeze

out viable firms in the rest of the economy, or the sort of borrower whose plans would help the

economy to recover its rapid growth on a sustainable basis”. (Honohan, 2008, December 02)

Honohan asserted that getting the policy package just right will be demanding for Ireland’s economy.

Honohan noted that what had been achieved in Ireland during the decade of the 1980’s, and resulted

in prosperity as seen in the early Celtic Tiger years, was as much a political, as an economic process.

18 Mr. Eamon Dunphy was so bold as to make a point to Deputy Fahey, that neither the Irish Government nor the European Central bank had any money. The only money that either had any access to, was that which they could receive from taxpayers.

54

The actions that are required on wages and salaries, on taxation and public spending, range well

beyond the narrowly financial. (Honohan, 2008, December 02)

55

W h a t i s N A M A s u p p o s e d t o f i x ?

Critically examine i ts progress in alleviating the aftermath and ‘f inancial

debris’ of the Irish Construction and property bubble.

Solutions such as NAMA are not intended to fix much of anything, despite the weight of financial and

economic theory that they are surrounded by. The main function of a project such as NAMA is to

restore political capital to government. The taxpayer on the other hand, will pick up the bill. In 2009,

Minister for Finance Brian Lenihan had convinced parliament and the public they would lose out by a

lot more, if a ‘toxic bank’ solution was not implemented swiftly.

Professor Vincent Reinhart has observed that, in the Clinton years of 1993-2001, the Democratic

administration was trying to find a role for itself. The message that President Reagan had preached to

the American public throughout the 1980s, was that government was a problem – not a solution.

(Reinhart V. , 2009)

President Clinton’s boyhood hero, President John F. Kennedy was a master at showing to the world,

an image of government that they could perceive as being youthful and vigorous. (American

Experience, 2012)

This kind of talk of easy solutions to difficult problems, if believed, could inspire a lack of

confidence among our people when they must all–above all else–be united in recognizing the

long and difficult days that lie ahead. (President Kennedy, 1961)

In the time of crisis in 2008, the Irish government paid millions in fees to international consultants

such as Goldman Sachs, for what former Minister Lenihan called ‘best international advice’. Many

former White House, and Capitol Hill staffers, who moved to the private sector, commanded rich

prices, for selling the old playbook to governments who wished to save the world.

“There is no market today. That is the problem”. (Fahey, 2009)

When one listens to the political message from government in Ireland after the 2008 crisis, it is

obvious who has written the play book, to save Ireland.

56

“Let me explain the context of what is happening with Liam Carroll (Carroll owed €3.0 billion

to various lenders in Ireland in 2009). If NAMA was in operation today, Liam Carroll’s

properties would be taken over by NAMA, and Liam Carroll himself would be liquidated. His

properties would go into NAMA.

They would be held by NAMA. They would be let out by degrees as the property market

returned. If Liam Carroll is liquidated through the courts process, and just say that Liam

Carroll owns fifty houses around where Eamon (Dunphy) lives, those houses would go at fire

sale value. It will totally destroy the market and destroy the banking situation.

Nobody will be able to buy a house or sell a house. Because they will not be able to get the

credit”. (Fahey, 2009)

The National Asset Management Agency is a solution, engineered by government and it represents a

massive intervention by government into the market.

“The reason that you cannot sell your house at the moment is because nobody can borrow,

because the banks can’t give anybody any money to buy it. That is the reason you cannot sell it.

When money starts to flow again, then the market will start to operate again”. (Fahey, 2009)

NAMA is designed to put political capital back into political parties, and not put financial capital into

private banks. Solutions such as NAMA are expensive make-overs, intended to make governments

appear vibrant and dynamic as President Kennedy did during his ‘Man on the Moon’, special address

to US Congress in 1961. (President Kennedy, 1961). Or why stop at Kennedy? Remember Lincoln’s

famous words in November 1863 at Gettysburg, Pennsylvania.

". . . that we here highly resolve that these dead shall not have died in vain - that this nation,

under God, shall have a new birth of freedom - and that government of the people, by the

people, for the people, shall not perish from the earth." (President Lincoln, Abraham , 1863)

With solutions such as NAMA in existence, the citizen in Ireland can feel safe and protected. The

good men and women of government are watching out for us.

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