This was written 7 years ago in the Spring of 2009
Before I knew about 'helicopter money' which has given a false, temporary, boost to the economy.
DEFLATION – THE KILLER BLOW
"There is no deflation threat in Europe" -- Jean Claude Trichet 1st March 2009
In February 2009, the Irish Central Statistics Office said that Ireland had an annual inflation rate of minus 0.1 per cent for January. This was the first time the country had negative inflation since 1960. Our rate of inflation for March was even worse at minus 2.6 per cent. This was the lowest level since 1933.
Ireland is now facing into deflation for the first time in more than sixty years.
But the government is unwilling to acknowledge that the debt crisis is a reflection of long-term problems and not just an isolated phenomenon. With the announcement of the latest figures they told us that, when house prices were exempted, the figures were fine. Of course, this was also the very same government that told us five years previously, during the property bubble, that if you exempted house prices the inflation figures were fine and the economy was in great shape.
And what was the Irish government’s priority in April 009, as the specter of deflation loomed large? Bailing out the
bankers who wrecked the economy in the first place, to the tune of €90 billion, instead of using those funds to reduce the burden of residential mortgage debt for every householder in the country.
But as Brian Cowen had already bellowed in the Dáil, ‘I’ll run the country the way I see fit," even though he knows (or should know by now) that his actions are going to seal the deal on a deflationary future for Ireland.
The warning signs were evident everywhere, neither Cowen nor his Finance Minister Lenihan would be able to say this time that ‘nobody saw it coming’.
Brian Cowen will go down in history as the worst Taoiseach this country ever had, especially if he turns recession into depression which is looking more likely with every day he remains in office.
The €90 billion he is proposing to hand over to his banker supporters is very possibly the last major tranche of taxpayers’ money available to turn our economy around and he has decided to hand it over to he very same bankers who lined their pockets with millions during the property bubble and bankrupted the nation in he process. The government’s proposals will have catastrophic consequences for our international borrowing capacity to fund a future recovery.
On 8th April 2009, Ireland finally lost its international AAA credit rating.
The Irish people need to wake up to what is happening to their country, before it is too late.
Fool me once, shame on you.
Fool me twice, shame on me.
I have tried to find positive avenues along which the country could be steered towards recovery, but just as it is necessary to look at our recent past in order to avoid making the same mistakes again, it is now necessary to state clearly that our government is taking actions on a daily basis which are bringing the country ever closer to a state of ruin.
On 9th April 2009, AIB and Bank of Ireland had their international credit ratings dropped. That was two days after
the government’s announced bailout.
The government might be pulling the wool over the Irish people’s eyes but the international credit rating agencies can see as clear as day what this government and the bankers are up to.
The international credit agency Fitch said that while the transfers to National Asset Management Agency should give greater certainty about the banks’ asset quality and potential future impact on their profitability, this will result in an acceleration of credit losses which will exceed profits and absorb capital. As a result, Fitch believes that further capital injections on top of the combined €7 billion already received may be needed.
Fitch added that it expects further deterioration in the asset quality of residential mortgages and corporate loans
books due to weaker prospects of the Irish economy and rapidly rising unemployment.
The bankers are bleeding Ireland dry and will go into bankruptcy in the end anyway.
But the government can no longer say they have not been warned repeatedly from numerous reputable international sources. Our GDP decline is accelerating.
Consumer demand is contracting sharply, as evidenced by all the ‘TO LET’ signs n the high streets and the 70 per cent drop in car sales.
People have stopped spending, many because they are out of work, but even the people who have money are not buying because they know things will be cheaper tomorrow and next year. The economy could now be sliding into a long deflationary period, which is what can all too easily happen if we have a large, sustained drop in output. Once prices start falling, and people start to expect continuing deflation, company balance-sheet problems will become much worse than they already are and much harder to resolve, leading to more and job lay-offs. This is what happened in Japan and now the same thing was also beginning in Ireland. A major cause of Japan’s ‘lost decade’ was the failure of their government to allow insolvent banks to go into bankruptcy, and Ireland’s government was now charting the exact same course for its economy.
In April 2009, deflation had become a very real and present danger for Ireland.
Deflation should, or so we thought, be easy to prevent: simply increase the money supply. Large economies with free floating exchange rates – like Japan, Euroland, or the United States – are free to expand the money supply as much as they like. So they should find deflation easy to prevent. But it has become clear from Japan’s experience, and more recently in the US and the UK, that it is not so easy after all.
In April 2009 the slump in Irish residential housing values had already wiped out all the appreciation in house -
hold assets over the past five years. Indebted households were being forced to cut back sharply in an effort to bring their debt into line. Instead of helping the Irish people in that regard, the Irish government had decided to burden the people with even more penal taxation rates. This would further hit spending all across the economy, preventing any chance of a consumer-led economic recovery.
With car sales down 70 per cent year-on-year and the sale of goods vehicles down 77 per cent, Ireland was now staring Japanese-style deflation in the face. Cautious consumers would defer buying because of falling prices, leading to further price cuts by businesses and consequent rising unemployment.
Unless the government takes immediate action, a deep recession could very quickly become a depression.
Deflation is not something many of us have experienced in our lifetime, as it last occurred in Ireland sixty years ago.
What is deflation?
Basically, deflation is when the price of a product or service will be cheaper in the future than it is today. This has the effect that people do not spend unless they absolutely have to, because if they wait things simply get cheaper. Given that a large part of our economy is driven by consumer demand, a reduction in consumer spending will have a catastrophic effect.
Adding to this problem, our consumers do not have very large savings (they had been convinced that their house was their savings), so they do not actually have much money to spend to start with. Their previous major sources of cash, which were credit cards, loans, re-financing mortgages and tax rebates, have all disappeared. Even viable businesses cannot get access to credit.
Deflation is turning out to be a serious problem for Ireland and we are going to find out that it is not as easy either to prevent or to reverse as we previously thought.
Causes of deflation
When consumers see that prices are falling and are likely to continue to fall, they have an incentive to delay their purchases. Why should they buy something now when they know it will cost much less later? This is known as a deflationary spiral.
The ultimate disaster in the current situation will be a vicious spiral of declining property prices and falling expenditure on consumption and investment. Bank losses will begin to spread from mortgages to consumer debt such as credit cards and car loans and eventually to business loans.
This will result in increased levels of toxic debts for the banks. This, in turn, could lead to a disastrous economic downturn.
Increased losses and falling expenditure will begin to feed upon themselves.
Deflation usually has the effect of increasing unemployment, since the process is activated by a lower level of demand in the economy. Lower demand leads to cut-backs in production. In December 2008, Irish factory production had fallen for the tenth month in a row.
Deflation can also be brought about by a direct decline in Spending, most likely through a reduction in one of the
following: government spending, personal spending or Investment spending.
Ireland is now suffering from a decline in all three.
The Irish banks can offer no more credit as their capital is all tied up in bad loans to insolvent builders and property speculators. A large proportion of these loans will never be repaid, but of course the bankers who issued them have already stripped out their huge bonuses for issuing the loans in the first place. They can now comfortably ride out the recession with their millions safely stashed away.
To understand inflation and deflation, it’s necessary to understand Supply and Demand. Just like every other
commodity, there is a supply of and a demand for money.
Money is simply something people are willing to accept in exchange for goods or services. Price levels are the direct result of the relationship between the supply and the demand for any given item and the value of the money is subject to the same relationship.
Let’s assume you are living on an island and there are ten houses for sale and a total of €1 million is available to
purchase them. In that situation, you can assume that each house will cost €100,000.
If the quantity of money increases to €2 million, without increasing the quantity of houses, the price of the houses will rise to €200,000; that’s inflation. If, however, the quantity of money decreases to €500,000, the price of the houses will then fall to €50,000; this is deflation.
The money supply can be reduced if somebody on the island hoards half of it and refuses to spend it on anything. This is the second part of money supply, a reduction in spending which is bad deflation.
But what happens if you build ten more houses? You now have twenty houses and there is still only €1 million to pay for them. In that scenario, the houses once again become worth €50,000.
This is the current situation in Ireland. We have a huge surplus of housing. But the houses have not yet been fully
reduced in price, because to do so would expose the bankers’ past practices and sink their businesses.
There is a saying on Wall Street: ‘You should never try to muscle the markets, because it’s you against the world.’ But the Irish bankers will twist and turn and do everything possible to avoid accepting that logic. They are currently advising the government to flood the market with money (recapitalisation) and that will fix the problem. But it won’t, because Irish people know that prices will still continue to fall.
Besides, the problems with Irish banks are not ones of liquidity, but insolvency. Supply and demand determines that houses are currently overpriced by around 50 per cent and the bankers will be forced to accept this truth in the end. How much damage the banks encourage the government to inflict on the economy prior to accepting this truth is something which should be of grave concern to us all.
What’s wrong with deflation?
If you don’t have any debt and you can hold on to your job, then nothing. That is why the politicians, with their
guaranteed incomes and gold-plated pensions are not too worried about all this; the taxpayers will pay their wages no matter how bad things get.
But the trouble is that deflation feeds on itself. Prices start slumping because there is less money available, and thus less demand. Shops have to mark down the cost of their products, profits fall and people lose their jobs. As more jobs are lost, demand keeps falling, which in turn causes more deflation.
During the Great Depression of 1929, unemployment rose from 3 per cent to 25 per cent.
Deflation also makes debt more costly to service – while inflation decreases the real value of your borrowings,
deflation increases it. That makes deflation very bad news for those who are heavily borrowed. Allowing things to take their course will eventually clear out bad investments made during the boom.
Politicians are very fond of telling us ‘doing nothing is not an option’. But in most cases they only say this to take the focus off of themselves, the ones who created the problem in the first place. The truth is that ‘doing nothing’ usually is the best way forward in a deflationary cycle. Look at the United States and Japan: they have cut interest rates to zero and it makes no difference.
When they go to zero interest rates, the US Federal Reserve then begins to target the money supply. This policy is known as ‘quantitative easing’. In reality, what happens is that they print more money and use this to buy Treasuries, bonds or other securities from banks to boost their reserves and get them lending again.
The Federal Reserve’s balance sheet has more than doubled in size during 2008, from $915 billion to $2,200
billion. It has provided loans and emergency credits to banks, brokers and foreign countries. In January 2009, the
European Central Bank (ECB) is also loaning money to Eurozone banks at 2 per cent. Unfortunately for both the
Fed and the ECB, they cannot force the banks to on-lend this money. Banks are well aware that in the current
recession there is going to be deflation, leading to a flood of bankruptcies (including many banks) and everybody is scared of lending. So ‘quantitative easing’ is not working, so far.
In the United States, the banks are hoarding the extra money from the Fed and as a result excess reserves have
jumped from $2 billion in August 2008 to more than $600 billion in January 2009. But the Fed and the ECB also have the option of lending direct to governments and this money can be used for capital infrastructure projects which will create employment and hopefully get the economy going again.
The problem Ireland is experiencing is that we have so badly mismanaged our economy that even the ECB is
becoming reluctant to lend us money. There is also a whiff of corruption in the air.
If Ireland were a person, would you lend him/her your money? Frankly, no: Ireland looks too much like a bad loan risk.