Morgan Kelly warns our real economic crisis will begin if ECB credit stops

First the boom, now the boomlet. Ireland really is growing again, with employment – the only reliable measure of activity in an economy like ours – up over 3 per cent in the past year. At the same time, the interest rate on Irish government debt has fallen sharply and house prices, in a few places anyway, have started to recover.

Not only do we seem to be recovering modestly, but the economic collapse after the bubble, although pretty horrifying, was a lot smaller than expected. The gigantic building industry imploded but, beyond that, there was surprisingly little contraction in other sectors.

This is all very puzzling. Conventional economic wisdom suggests it takes you about a decade to recover from a big credit bubble like ours. If you are lucky. And if you are like Japan you can still be floundering 25 years on. But here we are, hardly three years on from being cut from the wreckage of the Celtic tiger and requiring huge transfusions of European money, in something less than rude good health admittedly, but unquestionably back from the dead.

Save the euro

The source of Ireland’s seemingly miraculous resurrection lies in two magical syllables. No, not “En-da” but “Dra-ghi”.

Faced with the very real prospect that the euro would collapse under the weight of insolvent banks and governments in the European periphery, ECB president Mario Draghi undertook to do “whatever it takes” to save the euro. In practice, this has involved a policy of low interest rates, and unlimited credit lines for governments and banks.

Since Ireland popped down the green pipe into the world of Super Mario we have found ourselves effortlessly jumping over our crushing national debt, insolvent banks, a massively indebted private sector, and all the other obstacles to recovery.

It is not because anyone believes the Government when it says that our national debt of 125 per cent of GDP is sustainable and that Ireland can now borrow at low rates, but because the market knows that Draghi has underwritten the value of our debt.

In normal circumstances, no sane person would keep their money in banks haemorrhaging capital as fast as Ireland’s through mounting bad loans. But in a world where banks can effectively borrow unlimited amounts at near zero interest rates from the ECB, notions like capital adequacy become anachronistic.

It is not only the Irish Government and banks that have Draghi to thank for hauling their chestnuts out of the fire, but the private sector as well. For households and firms struggling under the huge loans they took on back when we all thought we were rich, low interest rates and banks that can hardly be bothered to chase down bad loans have made the post-bubble hangover a lot less agonising than might have been feared.

Nowhere is Draghi’s wizardry plainer than in our exit from the bailout. The sale in December of €500 million of government bonds at rates slightly above German ones was trumpeted here as national resurrection and in Berlin as vindication of the view that European peripherals can only recover when they start to admit the error of their spendthrift ways. However, behind the narratives of redemption and a triumphant return to the markets, with international financiers vying to lend to a newly creditworthy Ireland, the dismal reality is that these bonds were bought entirely by the State-controlled (or effectively controlled) banks AIB and Bank of Ireland with money slipped into their pockets by the ECB.

The artificiality of our supposed recovery is equally evident at the epicentre of the credit bubble: the housing market. Normally after a big borrowing binge and associated bubble we would expect prices to fall sharply and to stay low for a very long time, as banks cut off the supply of new loans and boot people who cannot repay their mortgages out of their houses. Neither thing has happened here.

With banks under no real pressure to repair their balance sheets, there have been almost no foreclosures. The flow of new mortgages has fallen, certainly, but a lot less than would have been expected. Mortgages are now being given only to couples who are both working in the public service (broadly defined to include health and education). As a result, while prices are still falling in large parts of the country, in places where a lot of public servants want to live, like south Dublin, they are rising.

So, things did not get as bad as they might have, and have started to improve a little, all thanks to Super Mario. Where Irish houses used to have pictures of the Pope and JFK, in future years we may see portraits of Draghi beside Brian O'Driscoll.

Bank solvency

So, what could possibly go wrong? The answer, in one word, is Draghi.

While Draghi has been successful in channelling credit to less than creditworthy European governments and banks, the other big problem of the European monetary system has been left unfixed: bank solvency. There have been repeated stress tests of banks, where the ECB promises that this time it will look coldly at the bad debts of banks across Europe and force the dodgier ones to get more capital. However, each time, faced with the likely cost of dealing with these bad debts, the ECB has looked the other way.

The problem now is that the ECB is talking of doing a serious clean-up of the bad debts of Irish banks. Presumably this exercise is intended as a trial run to iron out any wrinkles before sorting out the banks in economies that people care enough about for screw-ups to have real consequences. Any clean-up of the Irish banks would mean a sudden, rude awakening for indebted households and small businesses.

Right now, a lot of small firms whose owners ran up big property debts, often on company lines of credit, are surviving on the sufferance of their banks. Unlike larger firms that can be sold on as going concerns to new management, for most small firms their main asset is their owner. Under an ECB-led clean-out, many of Ireland’s SMEs would face sudden liquidation.

The Irish economy is unusual not only because it has a lot of foreign firms (about one sixth of private-sector employment) but because it has very few large firms otherwise. An extraordinary fifth of the private sector works in manufacturing or service firms with fewer than 10 employees ("micro-firms" in the jargon), and another fifth in firms of up to 50. Beyond vague statements by the Central Bank that many of these firms have non-performing loans, we know almost nothing of their financial position, and the possible damage that the sudden disappearance of heavily indebted ones might inflict on the Irish economy.

SME property debts

Everyone is focused on the bad debts of SMEs as a threat to bank solvency (they are a small one, at least compared with mortgages) but the real issue is the threat to employment. I have particular fears for micro-firms (remember, they are individually tiny but employ one fifth of workers in the private sector) who are already facing pressure from banks and the revenue, often for debts of under €10,000. Since I voiced these concerns in a recent talk to the UCD Economics Society, a lot of people have confidently stated that the threat is overblown, although where they get their information on the solvency of micro-firms is uncertain. Given that these are the same eminent economists who said that house prices would have a soft landing, the banks were fundamentally sound, and the Irish State solvent, it is hard to decide whether to be relieved by their assurances, or even more worried.

A simple way to minimise the damage of outstanding SME property debts to employment is to separate the property debts from firms that pass a basic level of viability in terms of debt per employee, and re-evaluate firms’ viability after two or three years. However, in order for this process not to turn into a bottomless trough of political patronage, it must be done transparently and openly, with the precise financial state and loan terms of any firm receiving a debt moratorium being made public.

In other words, we should do the opposite of what has started to happen with mortgages. Banks are starting mortgage forgiveness – reducing the amount owed by tens or sometimes hundreds of thousands of euro. This is a sensible way for banks to minimise their mortgage losses – if someone cannot afford to repay a €200,000 mortgage but can repay €150,000, the bank is better off reducing the principal, instead of foreclosing and only getting back €100,000 – but its implementation is anything but sensible. We have the largest State-owned company, AIB, starting to dispense millions of taxpayers’ money to unidentified people that satisfy unknown criteria – some cynical people have suggested that what rugby or hockey playing school your children attend may not be an unimportant factor – and nobody thinks that this is a problem. After all, if there is one thing we learned from the crisis it is that the judgment of bankers is to be trusted absolutely!

While there are wisps of smoke emerging from the SMEs, the flames have already engulfed the other engine that powered our take-off in the 1990s: the universities. Irish universities were never any great shakes but they did do one thing well, which was to produce a lot of well-trained graduates at extraordinarily low cost to the Irish taxpayer.

Despite the IT revolution, university bureaucracies have grown everywhere, with OECD countries now averaging two administrators for every three academics. But in many Irish universities, academics now make up less than one third of the staff. UCD alone employs 70 administrators (earning an average of €75,000 each) to compete against similarly lavish outfits in other Irish universities for Irish Government research grants that have effectively vanished.

Dreadful university system

With a bigger slice of a shrinking pie going to administration, the numbers of academics in Irish universities have fallen sharply – by more than 20 per cent in UCD – with more able young academics making up a disproportionate share of the exodus. Irish universities have plummeted in international rankings, with UCD falling from

100th to 200th in the world in the reputable Times Higher Education Rankings: the second steepest fall ever recorded.

A lot of people think universities are recreational facilities for middle-class kids and that their academic quality does not matter, but the examples of Spain and Italy – whose university graduates perform worse on simple tests of literacy and arithmetic than Japanese who have only been to secondary school – show how a dreadful university system can wreck an economy’s prospects. While SMEs will eventually recover from their debt overhang – this sector is nothing if not resilient – the policy of replacing academics with administrators probably means Irish universities are broken beyond repair.

There is always less to miracles than meets the eye, and Ireland's recent recovery is no exception. Instead of our frenzied borrowing binge ending in prolonged cold turkey, as a fortuitous result of the wider eurozone crisis the ECB has kept pumping that sweet, sweet credit into our veins. Should it stop suddenly, most likely through a final clean-up of bad loans at banks, our real economic crisis will begin.

Morgan Kelly is Professor of Economics at University College Dublin