Sunday, November 28, 2010

Irish financial crisis has lessons for Americans

Published in The Tennessean, Sunday, November 28, 2010

Irish financial crisis has lessons for Americans

by Richard J. Grant

The current Irish financial crisis offers lessons to Americans. First, we can learn a lot about fiscal prudence and economic growth from the preceding Irish history. Through the mid-20th century the Irish, like their British neighbors, abandoned common sense in favor of the pseudo-intellectual promises of socialism (what we call “progressivism”). The role of state involvement in their lives grew and their economies stagnated.

Just as the Thatcher revolution pulled Britain back from the precipice and restored, at least temporarily, the people's dignity, the Irish went one better. They cut government spending and tax rates aggressively. They removed trade restrictions and brought down their inflation rate.

As a small country, with a population just under 4.5 million, they needed to offer clear advantages to business in order to stand out from the crowd. They learned well from Thatcher, but perhaps Ireland's most important inheritance from Britain was rule-of-law principles and a common-law legal system that served to protect private property.

In 2007, Ireland's net public debt was only 12 percent of annual economic production (GDP). Compare that to the United States, where net public debt (which excludes the portion of debt held by US government agencies, such as the Social Security Trust Fund) is currently around 62 percent of GDP. (Total U.S. public debt outstanding is 93 percent of GDP.) By world fiscal standards, Ireland was in great shape.

Ireland was so attractive to investors that its banking system grew disproportionately to the size of the country. And bankers who had grown up in a world of government-run deposit insurance schemes and the expectation of government and IMF bailouts succeeded in business without fully developing their sense of prudent restraint. Further, Ireland had delegated control of its money supply and, therefore, interest rates to the European Central Bank (ECB).

During the middle of the last decade, the ECB, like our own Federal Reserve, pushed down interest rates to stimulate recovery from the tech downturn. That set us up for the most recent recession and real-estate downturn.

Government officials rarely foresee or react correctly to the systemic risks created by government-granted monopolies in the supply of money and the power to manipulate interest rates. The Irish blunder, which was the granting of a government guarantee for most of the loans in the banking system, could have been avoided. The Irish government was too small relative to its banking system to make good on such guarantees and, unlike the US government, it no longer had the power to print money to cover its guarantees.

When Ireland joined the European Union, it put its national sovereignty at risk in order to reap the benefits of living in a large free trade zone. Now, however, it has put its national sovereignty at further risk by blundering into the sphere that should have been reserved strictly for private action. Instead of letting the banks and their creditors learn to bear the burden of their own actions, the Irish government made promises that will overburden its taxpayers.

To get a bailout from the EU, Ireland faces demands from EU members that it raise its corporate tax rate. This won't help Ireland, but the intention is to make it less competitive so that other EU states don't have to make the effort. This is how American states have sold their own sovereignty to their federal government.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

Richard J Grant archived at The Tennessean

Sunday, November 21, 2010

European Union will bail out Irish mistake

Published in The Tennessean, Sunday, November 21, 2010

European Union will bail out Irish mistake

by Richard J. Grant

Four years ago, the government of Ireland was running a healthy budget surplus. During the previous 20 years Ireland had transformed its economy into the envy of Europe.

Until the early 1980s Ireland had been a big-government, high-tax, high-inflation, high-unemployment land of economic stagnation. Its main export was people. Government spending consumed more than 50 percent of its economy. The corporate income tax rate was 50 percent and the top personal rate was close to 60 percent. The inflation rate had been in double digits for much of the previous 10 years. Ireland had been phasing out its protectionist tariffs, but in the mid-1980s its unemployment rate reached 17 percent and its economic growth rate was still only about 2.3 percent.

By 2006, Ireland's corporate tax rate was 12.5 percent, the lowest in Europe. Its top personal income tax rate had dropped almost to 40 percent. Government spending was less than 35 percent of gross domestic product (GDP). Tighter control over the money supply kept the rate of price inflation down around 3 percent.

During the previous 10 years, Ireland's growth rate had averaged 7.4 percent and Irish income per person grew to be 10 percent higher than that of the United Kingdom and 20 percent greater than in France and Germany. Irish expatriates had good reason to return to their homeland, and many did. Foreign investment flooded in as well.

As Irish wealth grew, many people bought property. There was big demand for housing and office development. And with the European Central Bank holding interest rates low, credit was easy for construction loans and mortgages. It seemed natural for property prices to keep rising. The banks grew more promiscuous in their lending while regulators grew more complacent.

The Irish property bubble was not the only one in the world to pop in 2008. As was the case in many other countries, the magnitude of the bad debt problem was not immediately recognized. The banks were in serious trouble, but the regulators mistook the signs of insolvency for a mere lack of liquidity. They believed that the stronger banks could absorb some of the bad loans of the weaker banks, and that the Central Bank of Ireland (which cannot create money) could supply sufficient reserves.

Depositors began to pull their funds out of the banks, so bank reserves kept shrinking. Existing government deposit insurance seemed no longer able to ensure depositor complacency. That was when the Irish government made an innocent, but big, mistake.

The government decided to end the crisis by guaranteeing every deposit as well as most of the debt issued by Irish banks. The finance minister believed that this would restore confidence in the banking system thereby solving the liquidity crisis with very little more cash.

The finance minister would soon learn just how expensive a credit guarantee can be. He had, in effect, issued a credit default swap to the banking industry free of charge. He nationalized the losses of the banking industry. Taxpayers now carry the burden.

The surpluses and balanced budgets of the “Irish miracle” have given way to increasing deficits. The budget deficit is expected to rise this year to 32 percent of GDP.

The Irish government has bravely insisted that it can carry the burden. But it will soon accept a bailout from the European Union.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

Richard J Grant archived at The Tennessean

Sunday, November 14, 2010

Burdensome regulations slow economic recovery

Published in The Tennessean, Sunday, November 14, 2010

Burdensome regulations slow economic recovery

Richard J. Grant

It is unfortunate that the Federal Reserve Act gives the Federal Reserve System three different goals to promote: maximum employment, stable prices, and moderate long-term interest rates. Riding three horses at the same time can be dangerous.

Fed Chairman Ben Bernanke simplifies matters somewhat by referring to the Fed's “dual mandate” to promote “a high level of employment and low, stable inflation.” But he is not shy about manipulating interest rates in his attempt to achieve the other two goals. With price inflation low and unemployment high, the Fed has attempted to raise employment by pushing down real interest rates.

This is why the base money supply has increased so drastically since mid-2008 and why prices did not fall more than they did at that time. Chairman Bernanke still believes that the inflation rate is too low and that more inflation can help increase employment.

The trouble is that the Fed does not really have the ability to maintain high levels of employment. Whenever it tries to do this, it just sets us up for the next boom-bust cycle. Its discretionary interventions are best described as disruptive and serve to reduce long-term employment.

Big increases in unemployment, such as we have now, are common symptoms of government-induced boom-bust cycles. But the president and Congress have made matters worse in their attempts to treat these symptoms.

Rather than let the market correct the mal-investments that were encouraged by government incentives, the president and Congress have slowed the recovery process by commandeering resources from the private sector while piling on more burdensome regulations.

Recovery and reemployment are overdue and will be slower than necessary as long as the administration prevents the new Congress from reducing the size and obtrusiveness of government. The president will likely agree to stop tax rates from rising in January, but he is unlikely to acquiesce in the repeal of his cherished, but destructive, health-care and financial regulation laws.

Nothing that the Federal Reserve can do will overcome the job-destroying effects of the administration's heavy handed fiscal and regulatory interventions. The so-called “stimulus” program served only to squander time and resources. Attempts to prop up home prices and failing businesses have delayed necessary adjustments. Attempts to regulate everything from credit to carbon dioxide have created an atmosphere of regime-uncertainty in business and the wider society.

Businesses have streamlined their operations to maintain profitability and to ensure their survival. They will be reluctant to hire new workers until they can see more clearly what the likely costs of future taxes and regulations will be.

These fiscal and regulatory burdens were not imposed by the Fed. But in its attempt to overcome their effects and to boost employment, the Fed risks failure to maintain low inflation and moderate interest rates.

The Fed's previous manipulations of interest rates have induced the booms and precipitated the busts that panicked the government to react with stimulus packages and other ill-conceived interventions. It does not help us that the Fed, in turn, is now reacting to the government's policies with its own ill-conceived inflation of the money supply.

While producer prices are rising rapidly at home, the dollar is falling against currencies around the world. Perhaps it is time to reduce the Fed's discretion and look to a commodity price standard. We could, once again, link the dollar to gold.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

Richard J Grant archived at The Tennessean

Sunday, November 07, 2010

The Fed continues to create money out of nothing

Published in The Tennessean, Sunday, November 7, 2010

The Fed continues to create money out of nothing

by Richard J. Grant

Federal Reserve Board Chairman Ben Bernanke reminds us that the Fed responded to “the worst financial crisis since the 1930s” by purchasing more than $1 trillion worth of Treasury securities and U.S.-backed mortgage-related securities. This action took several hundred billion dollars worth of risky mortgage-backed securities off the balance sheets of private financial institutions and put them on the Fed's balance sheet.

How did the Fed pay for all these securities? It used its unique statutory powers to create money out of nothing. In the last few months of 2008, the Fed doubled the base money supply to $1.8 trillion, and by the beginning of 2010 had increased it above $2 trillion.

Under normal circumstances, this would almost certainly have resulted in high double-digit price inflation. With all this new cash available, banks would have had plenty of excess reserves to lend, thereby greatly expanding the effective money supply.

But circumstances were not normal. With the property market in decline and the economy heading into recession, increasing default rates knocked down the value of mortgage-backed assets. With the asset side of their balance sheets shrinking, many banks found themselves to be more undercapitalized than usual. So when the Fed supplied them with cash, they did not lend it but held most of it as reserves.

This is why we had monetary inflation but not price inflation. Not yet.

The Federal Reserve Act, which brought the Fed into existence, gives it discretion “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Depending on which prices we look at, price inflation has been not much above 1 percent and was briefly negative. If we pretend that interest rates are “moderate” then the Fed currently scores two out of three.

But with the unemployment rate stuck over 9 percent, the Fed sees its mandate as unfulfilled. Unfortunately the Fed suffers from the same learning disability as the Obama administration: It does not learn from past mistakes. Just as government spending fails to stimulate long-term growth so does pumping-up the money supply fail.

On November 3, the Fed announced that it will purchase another $600 billion of longer-term Treasury securities through the middle of 2011. The base money supply will increase $75 billion per month. That is a 30 percent increase over eight months.

Does the Fed expect the banks to hold all this new cash as reserves? If so, then how does it expect to create even a short-term stimulus effect? If it does not, then how does it expect to avoid inflationary consequences? Only one member of the Fed committee that is responsible for this decision, Thomas Hoenig, sees the inflation risk as serious enough to dissent.

When the Fed makes large purchases of securities, it pushes interest rates below what they would have been. This creates the illusion of an increased supply of capital available as loanable funds. But, although the Fed can create money, it cannot create wealth.

The Fed gives its profits to the U.S. Treasury. So when it creates money to buy Treasury securities, it is ultimately covering government deficit spending with the money that it creates.

Does this mean that the deficit is covered without cost? No. The cost is borne by everyone that holds U.S. dollars and dollar-denominated assets. Money inflation is a tax.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2007-2010

Richard J Grant archived at The Tennessean