BRIAN LUCEY: We are facing stagnation unless ECB can act

It takes a long time to recover from a banking crisis. If we’re unsure of that, we need but look around and notice that we are still talking and fretting about ours.

Seven years ago, Irish bank share prices were at or near all-time highs. Lending for house purchases and deposits inflows to banks were also at all-time highs, as were house prices. And then it all began to unravel. The children born at the bursting of the bubble, who will carry the cost most of their working life, are now in senior infants or first class.

Still it isn’t fixed. Only this week do we see the first criminal trial arising from the banking shenanigans.

This week also, we saw a report by the EU which sharply criticised our lethargy in dealing with bringing criminal, especially white collar, trials to justice. The Cowen government moved neither swiftly nor decisively when the storm hit.

But things may be changing. At the annual meeting of the Allied Social Sciences, a sort of Woodstock for economists and like-minded folk, a paper was presented on banking crises. Reinhart and Rogoff have previously come in for some (more or less justified) stick on account of a missed spreadsheet error in one of their papers.

The paper in question was at the heart of the meme propagated that after 90% debt/GDP countries enter a death zone. However, to my mind their more important work by far is in economic history, where in a series of books and papers they have provided comparative data on banking crises and bubbles. Much of the problem with modern macroeconomics is a twin crisis of insufficient data and lack of historical perspective. There is no excuse for this in the area of banking crises.

The paper provides details of 100 banking crises. The main finding is that the effects of the crisis take a long time to peter out. In half of the cases, real GDP per capita has not recovered to pre-crisis levels even after six-and-a-half years. On average, it takes seven years. Ireland has had a really severe banking crisis.

In terms of the post-Second World War period, it ranks in the top 10 most severe crises as measured by declines in per capital GDP. What is apparent is that we may, based on the real GDP per capita data available, be right on target to be an average recovery.

Our GDP figures are somewhat distant from the reality of people on the ground, but the fact remains that GDP is what the rest of the world measures as being available for the state to distribute. That we have chosen to in effect shelter a large chunk (the foreign direct investment sector) is our own decision.

This does not mean we are out of the woods. Entering the crisis with a healthy debt to GDP ratio of 25% in 2007, we are exiting it with one closer to 125%. Whether high debt causes slow growth, slow growth high debt, or more likely both working together, this ratio needs to come down.

Herein lies a problem. Europe and Ireland are teetering on the brink of deflation; we are used to inflation-rising prices.

Deflation, however, is where prices fall. While inflation can be bad at high levels, deflation at even moderate levels is disastrous. With deflation there is little incentive to spend — prices will fall so why spend now?

There is little incentive for firms to invest in new products – demand will depress until people consider that prices are likely to stabilise or rise. For those with debts, including states with high debt/GDP ratios and households with mortgages and personal debt, it is ruinous as the real level of debt increases over time.

At a wholesale level, the price companies get, deflation is already a reality. Across a wide swathe of the economy, prices have been falling for six months or more.

This is particularly evident in manufacturing and related areas. Indeed, surprising as it may seem to the consumer, it is also the case in most food areas, save dairy. At the consume r price level of the 12 main categories of goods and services, six have shown deflation in the last two months.

Since 2010, deflation has been the norm in clothing, furniture, communication, and recreation. At a European level, overall inflation is now close to zero. What is needed is moderate, 3% to 6% inflation. The ECB is again in the firing line, as it controls the money supply. However, facing broken banks and close to the zero interest rate bound, there is a limit to what monetary policy can do.

Eurozone governments cannot pump inflation by fiscal means as they are constrained by the various macroeconomic treaties. We are heading for a decade or more of stagnation unless the ECB can both clean the banks and prime the pumps. What’s the chance of that?


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