For quite some time now I have been of the view that there are a number of striking similarities between the goings on in Ireland and those in California, none of them good. Both locations have seen extraordinary rises in home prices turn to massive busts. As a result, both locales have seen depression-like collapses in consumer demand and the local economy. Unemployment and government deficits are surging in both California and Ireland. But, both California and Ireland have zero control over monetary policy and this is the crucial connection.
Let’s rewind a bit to 1999 when the Euro came into being. Ireland was a founding member of Euroland. So, on January 1st of that year, the Irish fixed their currency the Punt to the Euro for good at a rate of 0.7876. From that time forward, Ireland effectively had no control of the monetary spigot. By 2002, Punts ceased to exist as money in Ireland and the Euro was ushered in.
What this change meant for Ireland is that it had the many benefits that go with being part of a large single currency market. Among the many advantages of a single currency are reduced foreign exchange costs, less currency volatility, less chance of a run on the currency, and a greater certainty in business planning that results from those benefits. And these benefits can be huge in times of crisis – just ask Iceland.
There is a problem though which I mentioned before, namely the Irish have no control over their own money. To be sure, hard money types probably see this as a good thing as it prevents countries inflating to get out of an economic pickle. But, the alternative for the Irish has been depression.
Back in February, I mentioned this problem in a post called “The European Problem.”
The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank (ECB) in Frankfurt.
The problems mount in recession. Some members are getting devastated. Spain, for instance, is in depression already with unemployment at 14%. Ireland’s national budget is imploding with estimates for deficit reaching 10-12% of GDP. If you are Spain or Greece, you would like to print money– a lot of it. But that’s not happening in the Eurozone yet.
The result is a potential national bankruptcy for the likes of Ireland, one reason their credit rating is suffering. Will Ireland go bankrupt? Perhaps. It is unclear how willing other Eurozone members would be to support the country were it to run into that kind of difficulty. The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency. Bailing out a Eurozone member would come with many strings attached.
Then, there is the case of Austria. They too are in the Eurozone. They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85% of Austrian GDP. (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud). If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).
So, Ireland, having no other choice, must cut spending…drastically. Ambrose Evans-Pritchard reports.
Events have already forced Premier Brian Cowen to carry out the harshest assault yet seen on the public services of a modern Western state. He has passed two emergency budgets to stop the deficit soaring to 15pc of GDP. They have not been enough. The expert An Bord Snip report said last week that Dublin must cut deeper, or risk a disastrous debt compound trap.
A further 17,000 state jobs must go (equal to 1.25m in the US), though unemployment is already 12pc and heading for 16pc next year.
Education must be cut 8pc. Scores of rural schools must close, and 6,900 teachers must go. “The attacks outlined in this report would represent an education disaster and light a short fuse on a social timebomb”, said the Teachers Union of Ireland.
Nobody is spared. Social welfare payments must be cut 5pc, child benefit by 20pc. The Garda (police), already smarting from a 7pc pay cut, may have to buy their own uniforms. Hospital visits could cost £107 a day, etc, etc.
I hope this sounds familiar to American readers because this is exactly the scenario faced by California. The state does not have the option of going out to the California Federal Reserve Board’s backyard to pick a few ten billion dollar notes off the money tree. This is a privilege reserved for the U.S. Federal Government, one I would add that has the Chinese worried. Effectively, California is to Ireland as the United States is to the Eurozone. And that spells depression for California. Here are a few headlines:
- California prepares to shut 220 state parks to make up budget shortfall
- California’s Crisis Hits Its Prized Universities
- California closes state offices to save cash
Welcome to Reykjavik on the Pacific. Don’t think this train wreck happened overnight. It has been building for months. I first asked in October of 2008 is the State of California bankrupt. Technically, they are not. But, when a state refuses to honor its bills by handing out IOUs, that’s bankruptcy to me.
It is going to get worse for California. That is for sure. The problem here again is the depressionary bust that is likely to take hold as California starts firing workers and cutting spending. Remember, people with no jobs have little income. And having little income means foreclosure, which also means a surge in housing inventory and falling prices. That’s a recipe for still more foreclosures, continued house prices declines and a deflationary spiral. I imagine Wells Fargo and Bank of America would be rendered insolvent by such a scenario. So why is Obama balking at lending a helping hand?
I anticipated a bust in California and a helping hand from the Obama Administration, because I figured they wanted to mitigate worst-case outcomes. As far back as January 2nd, I was already saying this was the likely scenario. I asked “Will federal largesse be countered by state and local cutbacks?”
There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption. In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.
But, in the United States, there is a bit of a problem: state and local governments. They will not, and often cannot, spend. In fact some will be cutting. Will local government budget cuts undercut federal fiscal stimulus?
Yes. Yes. Yes. Doesn’t the Obama administration see this? I would argue they did not understand this in January or the stimulus bill would have been larger and more front-loaded. But, perhaps they do now, but have chosen not to act because every state and municipality in America would be looking for a handout if they did try to act in California. So, we’re in bit of a pickle here.
The foregoing analysis can’t leave you feeling like recovery is imminent in Europe or in America. Certainly, it is not in Ireland or California. The problem is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You cannot have all three. And California and Ireland both lack the monetary escape hatch. Depression will set in.
I see only three choices to solve this problem.
- Bailouts: Of course, we are going to see requests for transfer payments here. Will Obama bite? Will the Germans block this, afraid that the Austrians and Spanish would be next? Obviously, transfer payments are part and parcel of a monetary union in order to achieve economic harmonization. In the U.S., California gets less in federal largesse than it pays in taxes. This is a fact. However, it is looking ever less likely that this fact will help Schwarzenegger receive the help he wants.
- Backdoor currency: Marshall Auerback has argued that the IOUs in California are a backdoor currency system. No, they are not legal tender. But, in a note to me, he said “California can turn its warrants into sovereign currency by agreeing to accept them in payments to the state. Note that I AM NOT arguing that California should make them “legal tender, payable for all debts public and private”—this is something it cannot do. But you could basically reduce the cost of CA’s borrowing substantially via this device and essentially reduce the need for muni bond issuance. In fact, the implication that flows from my analysis is that you’d want to buy every single muni bond in sight as the IOU, by giving it an intrinsic value to pay state tax, effectively eliminates the need for muni bond issuance.” Could Ireland do the same?
- Immigration: People are just going to have to move. As jobs disappear in Ireland and California, the Irish and Californians will need to emigrate elsewhere. They have a huge market to chose from in both cases.
None of these are great options. I wish I had something more uplifting to say here. But, that is the situation we face.
Originally published at Credit Writedowns and reproduced here with the author’s permission.