Who`s Comfortable with a Recession

31^st October 2008
The Malta Independent - Friday Wisdom

This must sound really weird. Surely nobody ought to be comfortable with the onset of a global recession likely to be on a scale not seen since the early 1980s. But don’t bet your bottom dollar on it.

Our government is probably comfortable that a recession is coming so early in the term in office. If there is anything governments shudder at is having a recession towards the end of their mandate.

President Clinton had coined the term ‘It’s the economy, stupid’ to explain that the state of the economy is the single most important factor which influences the electorate’s judgement when voting out incumbent governments and voting in alternates that carry no guilt, being out of office, for the economic woes that afflict society at election time.

Many would argue that the US financial turmoil, which spread internationally especially after the Lehman Brothers bankruptcy, has damaged John McCain’s bid for US presidency in spite of his unveiled efforts to disassociate himself from fellow republican outgoing President Bush’s economic management.

Gonzi’s government should therefore see a lot of political mileage in facing an international recession so soon after being re-elected. Most governments spend like there is no tomorrow in the run up to an election and then slap on the brakes in the first half of a legislature. That is exactly what the government has done in the first eight months of this year where budgetary figures show a substantial under performance compared to the same period last year, let alone to this year’s expectations.

The onset of an international recession offers the government a formidable cover to make up for pre-election excesses without appearing mean and arrogant. Bombarded as they are with daily news about financial turmoil and international recession, people will have difficulty to distinguish between measures resulting directly from international factors and other measures resulting from purely domestic causes of over-spending to get re-elected by creating a false sense of feel good factor which now needs to be reversed to get back to reality.

Furthermore, if one has to face a recession, and these unavoidably happen once every economic cycle, it is politically convenient to face it in the first half of a legislature. This augurs substantial brightening up of the international economic environment in the second half as the world emerges from recession. It could permit government to face next general election at the top of the economic cycle.

This could sound hypothetical. There is nothing hypothetical, however, about the certainty of a general election by 2013 and the likelihood that the world will start emerging from the recession somewhere in 2010 to reach an economic peak of the cycle some two years later. The Gonzi government could well see the recession as a disguised blessing for its political fortunes if not for the country’s needs.

It has to be careful is not to push its luck too far too fast. The temptation to apply all the medicine early on the legislature and cover the cure for home grown illnesses with the restructuring needed to withstand the threats from an international recession, is politically attractive. It could well be economically deadly.

This is nowhere more apparent than in the revision of the restructuring of utility bills. The government is abolishing instantly subsidies that it had sustained for more than is prudent. Good economic management would have suggested that these subsidies should have been phased out long ago when the international economic environment was much more permissive. But that was politically inconvenient.

The government’s own figures show that government kept the surcharge frozen at 50 per cent between October 2007 and June 2008, leaving a few months cushion on either side of the March general election, even though the government was fully aware that mere cost recovery would have demanded a doubling of the surcharge.

Suddenly the government has converted to conventional economic wisdom and seems bent on not only stopping inbuilt subsidies but also to enforce recovery of past and future investment in infrastructure for the generation and distribution of water and electricity. The concession to phase out the capping applicable to major industrial users is being financed by overcharging other segments so that the whole cap subsidy in the phase out period remains revenue neutral for government. GRTU protestations in this regard are understandable.

This probably makes us the only country in the world that is raising energy prices at a time when energy commodity prices are coming down at astonishingly crushing pace. While internationally, governments are falling over themselves to prop up their faltering economies, ours proposes to add burdens on our fragile outfit. The slogan “we are all Keynesians now” has one exception and it is not the United States as conventional wisdom would suggest. On the contrary, the United States has thrown all budgetary caution (in any case there was little of it left under the “guns and butter” Bush administration) to the wind and is voting massive public investment to shore up its financial system and ailing industrial outfits which have been hurt by the credit squeeze.

Our government is an exception to the Keynesian trend. It seems to think that adding internally generated shock to exogenous tremors will give it political mileage down the road even if in the process it risks causing structural damage to the economy.

The Global Recession is Here

24^th October 2008
The Malta Independent - Friday Wisdom

There can be little doubt about it now. The credit and financial markets dislocations experienced since the collapse of Lehman Brothers will exacerbate the unfolding recession. Credit markets became so dysfunctional that central banks’ role suddenly changed this autumn from lenders of the last resort to lenders of the sole resort.

This will be the first time since the early 1980s where both sides of the Atlantic will go into recession at the same time.

It will be the first time that the eurozone faces a serious recession since the creation of the single currency and as such this will be an hour of truth for the euro. The depth and length of the impending recession will largely depend on the extent to which the emerging economies of Asia can keep their economies going on through their own internal dynamics, at slower but still strongly positive rate, even though they will be hit by a fall in demand for their consumer exports from the western markets.

I am hopeful that the recession will be much less painful than it was in the early 1980s. It is not just that I tend to be an optimist. There are sound reasons why this should be more manageable. Chief among these is that we are entering this recession with inflation peaking at historically low levels of around four-five per cent and there is clear evidence that inflation will trend substantially lower in the next few months as prices of energy and commodities are falling off a cliff, aggressively reflecting the prospect of falling demand from western economies.

The fall in inflation will permit substantial loosening of monetary policy with interest rates for the euro and GBP probably set to fall to the low levels where interest rates for the USD already are. This shock absorber will also be fortified by reduced cost energy inputs and a gain in competitiveness as the value of the euro and the GBP will fall substantially against the USD and the Japanese yen, and by consequence against the currencies of many emerging markets that are pegged to the USD.

Consequently, I feel that the euro area will fare better than the US in the upcoming recession as it should be increasing market share to compensate, albeit partly, for reduced global demand.

But there is a strong message for euro governments in all this. The euro rules and other sensible good financial housekeeping practices are meant to function properly in normal economic cycles that are not threatened by the sharp financial instability that shocks consumer confidence. It would be wise if these rules are not rigidly enforced in current circumstances. In Malta’s case, given that government has not had the necessity to fund recapitalisation of the banking sector, there should be no great need to depart excessively from pre-set targets. But given that government revenues will be hit from recessionary trends and that government will have to phase out subsidies more gently to avoid further shocks to the economy, we might have to accept that targets for a balanced budget will have to be shifted back.

Even before the current financial dislocation, government budget was wildly off track as a result of pre-election largesse. In normal circumstances, this would have been compensated by post-election withdrawal to regain sobriety; but in current circumstances, this would be a shock too far. So government can borrow an excuse from the international financial turmoil to justify its departure from the 2008 budgetary targets, even though such departure is entirely sourced from domestic causes.

One thing seems pretty obvious irrespective of the recession on the broader economy. The international financial markets will not go back to what they used to be any time soon. Once governments have been constrained to intervene and save banks by recapitalising them using taxpayers funds, regulation will have to be broadened and deepened.

There is no doubt that one of the main reasons why we are where we are today is the laxity of regulation, particularly in the United States, where most of the excesses occurred. I had already commented on this aspect well before the crisis unleashed its full force this last month.

My article in this series of 9 November 2007 was titled ‘Boring bankers’ and I had mused:

“There is another enigma with the business of central banking. When things are going well, central banks target their monetary policy to keep retail prices under control but take very little interest in asset price inflation. For example, the Central Bank never hitched their policy to control the real estate price explosion of recent years. When things turn bad, as is happening presently in the US housing markets, which inevitably spills into the financial markets and possibly on the general economy, central banks start cutting interest rates aggressively in order to stabilise the economy and create a cushion for soft landing.

But something is wrong somewhere. What applies to the downside should apply to the upside which can only be done if central banks include asset price inflation in their monetary policy stance and if they have direct regulatory control over the markets , not only in the banking sector but also on its periphery, that contribute to asset price inflation or outright asset price bubbles. The whole regulatory regime needs to be re-engineered in the light of the 2007 experience’

I never imagined however that I would be proved so harshly right so soon by the events experienced in 2008.

   

Apologise before You Leave

19^th October 2008
The Malta Independent on Sunday

President George W Bush has started his last 100 days in office before handing over to a new president who will be elected on 4 November.

When he leaves, Mr Bush will not only be ending his own presidency but will be sealing the end of the Thatcher and Reagan doctrine: the doctrine of free unregulated markets, of tax cuts and of little government.

Before he leaves, Mr Bush owes the world an apology. His failed presidency has been nothing short of disastrous – not just for America but for the whole world. He started by neglecting a growing risk of terrorist attacks, ignoring the advice of executives who bridged over from the Clinton administration, chief amongst whom was Richard Clarke, the terrorism czar, whose role was down-graded by the incoming Bush administration right at the time the terrorist threat started flashing red all over the place.

It continued with the pursuit of unilateralism and the adoption of the policy of pre-emption, whereby America gave to itself the right to start war on another country based on suspicion rather than on proven offences. This led to the disastrous Iraq war based on unreliable intelligence, deflecting focus from the real Al-Qaeda enemy in Afghanistan and without any idea of how to win the peace after winning the war. There was no reliable plan for disengaging from war after reaching the unrealistic objective of turning Iraq into a democratic beacon to be propagated in the rest of the Middle East.

But, as if that were not enough, Bush has saved the best for last. Under his watch we are seeing the meltdown of the US financial system for which he is responsible as the torchbearer of the Reagonomics doctrine for loose regulation, irresponsible tax cuts and the dangerous belief that the market could effectively regulate itself. Bush is seeing the US financial system crumbling in a manner that is more typical of a banana republic. It is humiliating for a superpower to suffer such a massive financial system failure and the US must know that there can be no geopolitical dominance that is not underpinned by geo-economic strength.

As the chief executive of the US government, President Bush has directly contributed to the financial turmoil in two distinct ways. He erred by keeping Alan Greenspan as chairman of the Federal Reserve when, by all reckoning, Greenspan had already overstayed his term since his original appointment in 1987 and should not have been re-appointed. Familiarity breeds contempt and Greenspan became too familiar with the financial system, expecting it to dance to his direction packaged in double-speak and cheerleading.

I well remember Greenspan reassuring the House and Senate Banking Committee that the US financial system was resilient and that the uncontrolled spread of complex financial derivatives was a healthy distribution of risk, ensuring that any shock would be absorbed without any institution being unduly damaged. I well remember Greenspan reassuring members that there was no bubble in the US housing market, only some froth at the edges in some states. He also claimed, in a dose of contradiction, that the Federal Reserve had no way of spotting bubbles in real time and that it was more effective to mop up afterwards than to try to deflate a bubble before it burst.

Greenspan was horribly wrong on both counts. When the real shock came, the financial system proved anything but resilient. Risk spreading through the use of complex financial derivatives, rather than by protecting the system, was actually its downfall. The lack of clarity about who was carrying the risk from the burst of the property bubble froze the whole system, with banks becoming wary of lending to each other in the absence of clarity about the financial state of health of the counter-party.

And the property bubble has proved anything but easy to mop up after it burst. What Greenspan had clearly under-estimated is the international dimension of the problem of the housing bubble, with various international banks being exposed and the US problems consequently being exported far and wide throughout the international financial system.

More bad choices were made by Bush when choosing the Treasury Secretary – effectively the US Minister of Finance or Chancellor of the Exchequer. He started well when he chose Paul O’Neill. But O’Neill was cautious and prudent and would not subscribe to Bush’s irresponsible policy of guns and butter. Neither would he support tax cuts at a time when the US was preparing for war.

He was quickly replaced by John Snow, with shallow experience in international finance and who was easy to mellow over to endorse Bush’s largesse policies which were to convert an inherited fiscal surplus into the frightening fiscal deficit, even when the economy was at the top of the cycle, let alone what it would look like at the bottom.

When financial matters started becoming complicated, Snow was replaced by technocrat Henry Paulson, who had cut his teeth as CEO of the largest investment bank, Goldman Sachs. Paulson was the right person to address the perceived major threat, ie the growing dependence on China for financing the budget deficit and the need to persuade China to loosen the strict peg of its currency to the US dollar to ensure it did not take undue advantage through an unrealistic exchange rate regime.

Paulson is, however, proving highly incompetent in handling the banking crisis. His decision to allow Lehman Brothers to fail and file for bankruptcy was irresponsible and highly damaging to the US’s international reputation. On what basis was the much smaller Bear Stearns salvaged with Treasury assistance when it was taken over by JP Morgan Chase and then Lehman was denied such treatment? If Bear Stearns was too interconnected to fail, then why was Lehman not considered the same? Subsequent events since that fateful weekend in mid September have proved that, in fact, Lehman was so interconnected that its bankruptcy has frozen the entire world financial system, rendering credit markets dysfunctional and throwing equity markets in an unprecedented freefall.

Bush’s failings have cost the world dear. Governments in Europe, Oceania and the Middle East have been forced to practically nationalise their banking system and guarantee their retail deposits in a desperate attempt to regain stability following the US shock. This has been done as a crisis-averting measure rather than as a political credo, and governments hope to disengage at a profit for the taxpayer when markets regain normality. But that could be a long shot.

In the meantime, the US is taking lessons from Europe on how the crisis should be managed. After keeping the world on edge for a whole week until the $700 billion bail-out package was approved by Congress, this is having to be remodelled on the EU system of recapitalising the main banks and insuring inter-bank dealings rather than merely buying off troubled assets from the banking system. Clearly, the US initial approach would have presented unfairly small and disproportionate potential rewards for the taxpayer for the risk of bailing out the banks, and this without actually addressing the underlying problem of diluted bank capital structures.

There is one lesson in all of this. In this global world, national regulators are no longer in control of the financial systems they are supposed to regulate. Even the best regulators are exposed to shocks resulting from the failures of regulators in other major jurisdictions, which raises the question of whether a global world needs a global financial regulator and whether the IMF could be reinvented to perform such a role.

Nauseatingly Familiar

17^th October 2008

The Malta Independent - Friday Wisdom

We have seen it all before and alas we are seeing the government playing it again, just like Sam. Whenever circumstances force it to take unpopular budgetary measures, out comes Minister Austin Gatt blaming everyone under the sun except the government he forms part of, explaining in forceful colourful language that reality can no longer be avoided and that the harsh pill of corrective economic measures has to be swallowed.

In so doing he prepares for the social partners sitting around the MCESD table, a menu of choices which vary from death through being pushed off a sky scraper or execution by a firing squad. Then after having mentally prepared the nation for a harsh shock, out comes the actual budget measure with very sour medicine but not as horrific as Minister Gatt would have had us believe. The people will thank heavens that it was not as bad as they feared and will praise the Prime Minister for striking a balance between economic necessities and social protection.

The time for such sickening games is long gone. This country needs strong hands on the rudder to veer us through the stormy economic waters that an unavoidable global recession could well bring. The economy must be spared a further shock that could kill the patients rather than massage them gently into adaptation to the hostile economic reality.

Let me set the record straight. I am in full agreement that long-term government subsidies to keep energy prices at unrealistically low levels are no solution. I also agree that there should be no cross-subsidisation across user categories and the current practice of households subsidising industrial and hotel users is regressive and should be abolished. The case against cross-subsidisation along product lines is less clear and I would have thought it makes sense to have higher prices for fuel at the pump to subsidise to some extent basic usage of utility units given that use of the latter is indispensable for basic standard of living whereas use of the former is more discretionary. But I can still live with the concept that no cross-subsidisation along product lines should be allowed and any subsidy should be paid directly and separately by the Treasury.

Where I part company with the minister is the base case assumption regarding current cost of procurement of an imported unit of energy at e0.14,7 per kWh.

This assumption is based on the premise that current costs of energy will remain in force for the long-term. The minister has boasted that hedging agreements saved the country e42 million for the year to September 2008 but with favourable hedging and all, current rates including surcharge at 95 per cent still would leave a hole of e55 million which government can no longer afford to subsidise.

Going forward, the fortunes of the hedging agreement are bound to turn negative as we seem to have hedged at high prices and will not benefit for quite some time from the sharp reduction in energy prices that have been experienced following the price peak of crude oil at USD147 last June. This is not meant as a criticism but purely to show that hedging is not a one-way bet. With crude oil price being so volatile, hedging could present pluses as well as minuses compared to spot rates.

So with a tight budgetary situation what is the best policy to ensure that subsidies are dismantled without shocking the economy more than it will be shocked through the hostile economic environment?

This country has been through such hostile environments before and successfully so. Perhaps Minister Gatt may learn from history and see how past Labour governments navigated past price shocks in basic commodities without structuring in permanent subsidies and without inflicting undue shocks, both economic as much as social.

To my mind, Minister Gatt would do well to consider a price smoothening mechanism similar to the Price Stabilisation Fund operated by Labour government in the 1980s. Price smoothening over the economic cycle is not a subsidy. It simply accepts the reality that over an economic cycle the price of oil will normally move from peak to trough within a spread of say USD50. Let’s take the price range as USD50 at the trough and USD100 at the peak with USD75 being the basic average.

The government should base its tariff on a cost of USD75 at a notional rate of USD1.30 to the EUR which is somewhere close to the purchasing power parity rate. Energy prices, including utility bills and fuel at the pump will be based on the actual cost of procurement within this channel and adjusted frequently to ensure consumer sensitivity to the prevailing international prices.

But there must be a policy that if the price of oil gets higher than USD100 or lower than USD50 these are not reflected in the price mechanism with USD100 being the cap and USD50 being the floor for fixing energy and utility prices for domestic consumption (i.e. excluding bunkering and airline fuel oil which are essentially for international consumption). If the price of energy goes beyond the USD100 mark, the difference is funded by the price smoothening mechanism and this funding is carried forward to be recovered at some future point in time when as normal cycles go, oil will fall below USD50. Any outstanding amounts which remain uncovered or undistributed within five years from origin will have to be reflected for recovery or rebating in future price mechanism by shifting the band higher or lower as may be necessary.

Within this context, hedging is to be used with diligence. For as long as the price of procurement stays within the price band of USD50 to USD100, little hedging is called for as the price movements are immediately reflected in the tariff price adjustments. Hedging is to be actively considered when the price moves outside the normal band with aggressive structural long-term hedging when the price falls below USD50, and tactical short-term risk spreading hedging when the price goes above USD100.

Sometimes it takes a bit of humility to learn from our predecessors when trying to address current problems and we should not assume that we know better simply because we are more IT literate than our predecessors who were used to back of the envelope calculations and human judgement compared to our current sophisticated computer modelling.

As the consequences of the international financial turmoil are showing, it tends to pay in the long run to keep things simple, sometimes as simple as back of the envelope calculations. After all, is it not the sophisticated practices of short selling, financial derivatives, excessive leverage, CDO’s, MBS and other complex securitisation acronym stuff that have brought us to the brink of international financial collapse? Is it not true that our conservative banking practices have saved us from Icelandic nightmares?

Those who thought they can take more risk because we have better and more sophisticated risk management tools have been proven wrong. Perhaps it was worth sticking to conventional back of the envelope risk controls.

   

Iceland Melts - Will Malta Freeze

10^th October 2008
The Malta Independent - Friday Wisdom

This has nothing to do with global warming. It has all to do with realisation that this world has apparently gone topsy-turvy.

Iceland and Malta are islands with roughly the same population sitting at opposite ends of the European continent. Nothing that island states their size can do normally finishes on international news headlines. Iceland has broken this mould.

At a time when financial news are making headlines in Main Street, at a time when financial instability and unprecedented volatility on the main world share exchanges is leaving operators breathless and investors perplexed, at a time when governments are being forced to take unthinkable measures in attempt to stabilise their financial markets, involving investment of astronomical sums of money to recapitalise their banks, offload them of troubled assets and infuse liquidity in money markets, yet tiny Iceland’s financial predicament still manages to make headline news.

This is happening because Iceland is the first western world developed country that is involved in a financial meltdown of unbelievable proportions. What has landed Iceland in such hot water, making this beautiful ice-bound island melt away financially?

In technical terms it is called leverage, in fact leverage in high doses. Leverage is when somebody, a person, a business organisation or a nation state, borrows far more than their economic circumstances can process productively and efficiently. Icelandic banks considered that their country was too small for their ambitions and rather than rely primarily on the deposits they collect domestically they started borrowing extravagantly on the international markets in order to finance the international projects and ventures by Icelandic entrepreneurs that wanted to punch above their weight on international market. Even in Malta we saw an Icelandic company take over a long established pharmaceutical company, which started under Dutch public ownership in 1974.

This brought temporary success and exuberance on domestic Icelandic markets, leading to excessive demand caused by living on easy credit which generated double digit inflation and balance of payments deficit of unsustainable proportions. These macro-economic imbalances weigh heavily even when the international economic background is rosy. When it turns chilly under the weight of a sharp credit crunch, excessive borrowing becomes unbearable as lenders start pulling back their credit lines and banks start losing their major currency i.e. the confidence of their depositors.

Iceland has lost the support of international lenders and its banks would have gone bankrupt if the State did not intervene to take them over and back them up by state guarantees supported by the nation’s balance sheet. Yet the nation’s foreign reserves position is very tight and in order to avoid a shocking depression the government needs to raise several billions of euro in foreign currency loans which are not available on a market suffering a serious credit freeze. Attempts to raise such finance bilaterally from the US or West European governments found no backing as these countries are struggling with their own domestic problems of dysfunctional financial markets.

Iceland had to resort to an unlikely source: Russia. Russia has extensive foreign reserves accumulated by strong balance of payments surpluses resulting from high prices of exported energy. What conditions will Russia impose on Iceland if it agrees to provide the finance requested is yet to be seen. But certainly it is not enviable to be in the shameful position Iceland has landed itself in. Iceland is in a financial meltdown from which it can emerge with difficulty after much pain over several years hopefully without compromising its sovereignty.

Thankfully in Malta we manage a much more conservative banking system. Our banks finance their operations entirely from domestic deposits and command a comfortable liquidity surplus which is deposited with the Central Bank over and above the regulatory reserve requirements. Banks do not lend funds to each other as they all have surplus liquidity so their end of day clearing operations are generally excessive liquidity placed with the Central Bank. Our banks are not exposed to the risk of losing international credit lines. As a nation our foreign borrowing is negligible and although our national debt is substantial this is held by domestic savers who are generally very willing to buy and hold till maturity.

Maltese savers can sleep comfortably in the knowledge that our banks are strong and safe. However Maltese households cannot have the same peace of mind about the cost of energy they are using as from 1 October. Knowing our disposition to cut the cloth to the size of our resources it is likely that if government proceeds with its intention to pass the full cost of energy to consumers many households will have to economise substantially on their heating this winter. Could we be heading for a winter freeze just while Iceland is financially melting away?

Let me state that from an economic point of view it is unhealthy to keep permanent subsidies as they lead to waste of scarce resources. But responsible macro-economic management should ensure that shocks are smoothed to avoid killing the patient rather than teaching him how to handle the new reality. Rather than smoothing government is accentuating the shock.

After pretending it can do magic to keep the surcharge at a ‘low’ 50 per cent in the months before and immediately after the election, now that goals of political convenience have been achieved, the government intends to force us to face harsh market realities and not only pay current contracted prices but also make up for past leniency.

With recession now clearly on the cards oil prices could permanently fall below $100 per barrel of crude and possible go back to $70 in the first half of 2009. The consumer should not be falsely duped by political exigencies and then shocked when reality cannot be avoided any longer. On the contrary responsible management should smoothen the market fluctuations by averaging acquisition price over the whole economic cycle and adjusting prices frequently to avoid one-off big shocks as government has been doing since the season of political convenience expired last June.

   

Contradictions Exposed

5^th October 2008

The Malta Independent on Sunday

This was the week when hidden contradictions were exposed.

Take the proposal presented by the government for the introduction of a new utility rate tariffs effective 1st October. This is meant to be a consultative process. But how can it be so if at the same we are informed that the new rates will become effective retroactively from 1st October 2008.

How can households run their budgets if they do not know the cost of electricity they are consuming? How can commercial organisations price their products and sign contracts if the rate of a cost input as important as energy is still up in the air and will take effect retroactively?

It is clear that too many problems were swept under the carpet in the run-up to the election, and it is seems that after taking a long summer holiday that government is now presenting society with very unpleasant fait accompli(s) which have to make up for extensive hiding of reality in order to facilitate getting re-elected.

Between October 2007 and June 2008, the surcharge on a hedged basis should have been, on average, 100 per cent. In fact it was 50 per cent and the government had committed itself to keep it at that level till June 2008. The government knew it was under-recovering actual cost but electoral convenience demanded that social aspects take precedence over economic ones. Now we are being presented with the real bill. Now we are told that utility rate setting should be merely an accounting exercise for recovery of costs incurred including not only direct cost, operational expenses and overhead recovery, but also a margin to provide for recovery of past investments and a new investment programme of €451 million over the next four years.

No wonder government proposals are under attack from practically every quarter – traditional friends as much eternal adversaries. Presenting these proposals without an analysis of its social and economic impact is an act of gross irresponsibility. Presenting them with the intention that they would have retroactive effect is an act of gross arrogance. Presenting them without explaining what sort of direct subsidies government can provide is the job of an accountant not of a government that has social and economic responsibility for the whole country.

This week also exposed an acute case of contradiction embedded in the set up of the Euro Monetary Union (EMU). When it was designed its founders knew that history was not on their side while trying to create a durable single currency for a group of individual sovereign States that are not underpinned by a political union. In the past, similar attempts were short-lived and ended in disintegration.

The euro founders must have been hoping for one of two things. Either that EMU would itself be a catalyst for the gradual formation of a political union to underpin it, or that the constituent sovereign States would closely co-operate and align their fiscal and financial policies to make them resemble the policies of a single State.

Such assumptions can only be validated when the system is under severe stress. And after 10 years of relatively stress free performance, we have now suddenly precipitated to the point where the financial stability of the constituent sovereign States has come under stress as US financial instability is exported to Europe, especially since Lehman Brothers filed for bankruptcy on 14 September.

The European Central Bank (ECB) is responsible for a common monetary policy for the whole euro area and statutorily is only responsible for keeping stable and low inflation with little or no responsibility for economic growth. Obviously, to achieve such inflation objectives it needs stability in the financial markets. It cannot perform in a situation where banks lose their credibility and depositors and investors prefer to keep cash under the mattress rather than in the banking system. But all the ECB could do to achieve stability at times of turmoil is to pump liquidity to keep the banks floating when their problems is one of illiquidity. It can do pretty little when the problem is one of insolvency caused either by the misfortune or mismanagement of one particular institution or by systematic failure caused by external shocks.

The responsibility for financial stability in such cases rests with the individual States, or in case of banks working across borders, with a group of such States. This week we have accordingly seen the Benelux countries salvaging Fortis with a direct equity capital investment, Belgium and France salvaging Dexia, Germany salvaging Hypo Real Estate, and Ireland giving a sovereign guarantee for all retail deposits held by Irish banks worldwide as well as foreign banks in Ireland holding Irish deposits

With this measure the Irish have released a bull in a china shop. They put pressure on other countries to offer similar sovereign guarantees, as otherwise there would be a shift of deposits towards Ireland at a time when the situation in most euro countries is unstable enough. Greece has already followed in the Irish footsteps and the big countries are meeting over the weekend to see whether they can come out with a co-ordinated response that would include all euro countries. Meanwhile, Italian Prime Minister Berlusconi promised no one would lose a euro of deposits in Italian banks, effectively giving an informal blanket state guarantee.

So what will happen now? Will all euro area deposits be covered by a State guarantee, or will a supranational organisation be set up to harmonise such matters without having one country gaining unfair advantage over the others? And what if the guarantee would need to be exercised? Like an insurance policy a guarantee is only reliable if it can be cashed when validly claimed. How will the Irish government make good for a guarantee for a value more than twice its GDP and still stay within the Maastricht criteria? Is it not an oversight that these criteria make no rules for the quantity of contingent obligations EMU States can take on their books?

The weekend summit is crucial for the future of the euro and for the stability of the European banking system. Without a broad agreement for setting up a common fund for recapitalisation of European banks to a more comfortable level that can withstand the severe stress of current financial turmoil, each country will have to fudge along on its own, adopting beggar thy neighbour policies more typical of the 1930s than of a monetary union of the 21st century.

Yet our government thinks now is the right time to have us bear the full brunt of the energy prices because EU rules do not permit subsidies, cross subsidies and unfair competition among its members. While other countries are bending the rules to protect their economies from these financial external shocks, our government thinks that in the midst of all this turmoil it is the right time to shock the economy further by the abrupt removal of energy subsidies with retroactive effect. Truth is that the government has lost control of public finances and is desperately trying to paper over the cracks without considering the long term consequences of its actions.

The financial turmoil has now damaged the international economy making a rather prolonged recession a near certainty. When the price of oil is heading down to more comfortable levels as a result of less demand due to the impending recession, our government is proposing to jack up internal market prices for energy to recover past shortfalls tolerated for its own political convenience. And in the process it takes cover by claiming that EU rules are forcing its hand when reality is that the EU is much busier putting out much bigger fires elsewhere.

Let's get serious!

The Law of Unintended Consequences

3^rd October 2008

The Malta Independent - Friday Wisdom

In submitting proposals for consideration to be included in the next budget a Church commission suggested that the government should charge a nominal fee on medicines presently distributed free and should also levy hospitalisation fees on those holding private health insurance.

I do not quite get it why a Church commission should be making proposals for the next budget. If the Church has any advice to give to the civil administration this should be on matters of strategy and general orientation rather than just join every Tom, Dick and Harry in submitting proposals for a short-term instrument as is a budget with life span of merely 12 months. Furthermore, the proposal to charge a nominal fee for dispensing free medicine had been tried by the Labour administration of 1996-1998, not as a means of raising funds, but merely as a measure to discourage waste.

Political opportunism led to the then Nationalist opposition crucifying the Labour government with cheap demagoguery rather than responsible burden sharing and no Church commission at the time did come out to defend a measure which remains as sensible today as it was 10 years ago.

More worrying however is the proposal to levy hospitalisation fees on those holding private health insurance. This proposal is based on a false premise that claims on private health insurance policies are funded by the underwriting insurance companies. That’s a fallacy. Insurance underwriters only manage the direct impact of such claims but ultimately these would be funded by the insured. If government starts claiming hospitalisation fees selectively on those who have opted for a health insurance policy, the increased cost of claims will be passed on the insured through increased future premiums. Ultimately therefore the hospitalisation bills for otherwise free state health services will be indirectly paid by the individuals who are caring enough to take out their own private health insurance policy.

The law of unintended consequences will therefore apply. When measures are not thought deeply enough there is a risk that one gets results which are diametrically opposite to those intended.

A perfect example of this is when the US Treasury last week extended insurance guarantees on all money market funds where many retail investors kept their liquid savings. Money market funds generally produce a slightly better rate of return than normal bank savings accounts but unlike the latter they were not covered by limited federal insurance deposit protection. The extension of cover to money market funds was meant to stop panic withdrawals from these funds causing confusion of the market. The aim was perfectly rational.

What happened in practice? Many savers started withdrawing money from the savings accounts and investing them in money market funds to get a better return now enjoying similar insurance protection. This created a problem of liquidity for banks that were faced with a sudden withdrawal of normally stable deposits. Clearly the US Treasury did not think through this measure deep enough and suffered from the law of unintended consequences.

The same would happen if the measure to charge hospitalisation fees for services rendered to private insurance policy holders were to be implemented. Human nature being what it is, the comparative disadvantage treatment meted out by the State on private policy holders will encourage many if not most to give up their policy, save the premium and start relying entirely on the free national health service.

In reality what we need is to move in the opposite direction. We should encourage as many people as possible to take out private health insurance by offering fiscal incentives. It is a proven fact that holders of private insurance policies, whenever they need hospitalisation services, will opt for private hospitals where they can enjoy more privacy and comfort. This optional choice made by private health insurance policy holders does in fact save the State a considerable amount of recurring expenses it would incur if the selective hospitalisation fees will force such policy holders to rely entirely on public health services. Hence the case for considering fiscal incentives to promote more people to opt for private health services.

Private health insurance policy holders would only opt for public hospitalisation services in the thankfully rare occasions where the medical or surgical treatment needed is complex enough to warrant relying on the more elaborate public health treatment even though in the process they would be sacrificing the privacy and comfort obtainable in private hospitals that are not as equipped for complicated cases as the general hospital is.

What we should be discussing, now that it is quite fashionable to break pre-election pledges, is whether it is feasible and economic for the long term to continue offering free universal health services across the board irrespective of the creeping health costs caused by more expensive treatments and the general ageing of the population.

Any sensible person would admit that the present system is unsustainable. If we persist in trying to square a circle what will happen in the long term is that public health services would have to be rationed or lowered in quality resulting in longer waiting lists, medicine shortages and poor services to in and out-patients. That would hurt those who by necessity have to rely on public health services and would in the long run force the more comfortable to re-take private health insurance as they become concerned that public services would not be as effective as they expect.

What we should be working upon to preserve sustainability and social fairness is the introduction of a compulsory national health insurance scheme with opt-outs for those who prefer private insurance. When we are all covered by some sort of health insurance the state health system will start charging reasonable fees for its services to render us more sensitive to the cost incurred by the general taxpayers for providing such services.

This obviously leaves the question of what cover can be offered to those who cannot afford to pay their compulsory insurance premium. We certainly cannot even contemplate the American system of leaving the most vulnerable uncovered. It would be up to the State to re-direct the funds saved as it is relieved from providing free universal health services, to the payment or subsidy of insurance premium to certain classes who by reliable and refined means testing (which tests not just the declared incomes but also the expenditure on life-style) are proven as not being able to pay the compulsory insurance premium.

This is by no means a blueprint but it could be a possible framework to work out a long term solution to a growing problem without falling into the temptation of quick fixes that suffer from the law of unintended consequences.