By Cormac Lucey
Humans adapt quickly to changed reality and soon take it for granted. Spring replaces winter, and we feel that life should always be like this. We almost forget the experience of winterish conditions, or that in a few months they will return. Similarly, when strong economic recovery replaces a brush with economic depression, we take the positive change for granted and assume that life should always be like this.
Just like the seasons, our economy follows a cyclical pattern where recoveries are inevitably followed by downturns. There are several factors that could provoke our next economic crisis.
Italy is the most high-profile source of risk. The Mediterranean nation’s new government relies on the support of the Five Star Movement and the League, two parties opposed to the core economic policies of Europe over recent decades. They have long disapproved of Italy’s membership of the euro and have promised to expel hundreds of thousands of illegal immigrants.
The country has experienced little economic growth since it joined the European single currency. Its national debt is running at 132% of GDP, compared with Irish national debt running at about 90% of GNI*.
The Italian government’s proposed economic programme calls for spending increases, a universal basic income, lower taxes and a lower pension age, putting the nation on a collision course with the European Central Bank (ECB) and financial markets. It’s similar to what Jeremy Corbyn is offering British voters: liberation from everyday economic constraints and the promise of summer every day, all year round.
In a 1932 election speech to farmers in Schleswig-Holstein, Hermann Goering proclaimed: “We don’t want lower agriculture prices, we don’t want higher agriculture prices, we don’t want the same agriculture prices: we want National Socialist agriculture prices.”
There has already been a sharp negative reaction to the plans of the Italian government. Ratings agency Fitch has warned that the populist coalition poses a risk to Italy’s credit profile. “This brings back memories of the early days of the current Greek government, which sought confrontation with Brussels in 2015 and triggered considerable market turbulence,” said Stefan Bielmeier, chief economist at DZ Bank, quoted in the business newspaper Handelsblatt. Last week the interest rate on 10-year Italian government bonds rose to 2.4%, having been at 1.8% at the start of the month and 1.2% around 18 months ago.
As was the case when Ireland slid into the arms of the International Monetary Fund/ECB/EU troika, the real action may be taking place elsewhere.
Back in 2010, key figures of the government assured us that Ireland had all the cash it needed for the next six months. It did. The more urgent problem then was a slow-motion bank run on deposits at Irish commercial banks. Their threatened closure was averted by the ECB lending ever greater amounts through the Central Bank of Ireland.
Between August 2010 and December 2010, our central bank borrowed an extra €88.8bn, bringing its debt to Frankfurt to €144.4bn, equivalent to more than €30,000 for every man, woman and child in the country. ECB alarm at the increasing risk on its balance sheet — represented by amounts owed by Ireland that might never be repaid — prompted the troika’s Irish mission. It was the head of our central bank, speaking from Frankfurt, and not our head of government, who first publicly announced that the game was up.
Over the three years to March this year, the Italian central bank has increased its borrowing from the ECB by €285bn, equivalent to nearly €5,000 for every man, woman and child in the country. The Italian government’s strategy of public confrontation with EU orthodoxy can lead only to an acceleration of those outflows and increasing heartburn at the top floor of the ECB’s headquarters.
It also threatens to escalate into an uncontrollable crisis that pits Italian politicians and citizens against their German counterparts. The Bundesbank in Frankfurt has increased its lending to the ECB since March 2015 by €375bn, equivalent to more than €4,500 for every German. Any concessions now to Italy can be portrayed as coming at the expense of Germany and its citizens.
Another threat is that a rising American dollar puts increasing financial pressure on emerging market economies and companies that have borrowed heavily in the US currency. The Bank for International Settlements has already warned that emerging market borrowing levels are far higher today than they were over a decade ago, when the global financial crisis started.
Argentina, which I thought had got its act together under a reformist government, illustrates the danger. Its central bank announced three separate interest rate rises in one week in an effort to shore up the peso exchange rate. Interest rates there now exceed 40%. What would such a hike here do to the value of a three-bed semi-detached house in south county Dublin? Emerging market financial crises can soon spread to developing markets — as the 1997-8 southeast Asian crisis showed.
In China, private sector credit has been growing at rates similar to those in Japan (1990), Thailand (1998) and Ireland (2008) prior to their crises erupting. While the Chinese could probably domestically contain the impact of bad loans, a sharp slowdown would greatly dampen the commodity prices on which the economies of Australia and Canada depend.
A domestic threat is the state’s dependence on flourishing corporation tax payments by the foreign direct investment (FDI) sector. Earlier this month Seamus Coffey, the chairman of the Irish Fiscal Advisory Council, told the Oireachtas committee on budgetary oversight that corporation tax receipts were likely to fall at some point because they were “inherently” volatile and highly concentrated around a small number of companies. “We should not be surprised, or taken by surprise, when this happens,” he said.
The final — and, in my view, most threatening — danger on the horizon is that of tightening global monetary policy and rising interest rates. That has been the significant factor behind the global economy’s past three downturns. It is a factor that is heading in plain sight.
It may be sunny, but winter is coming.
Published in The Sunday Times (Ireland edition)
May 27th 2018