The recapitialisation of Irish banks seems to be designed to restore them to their previous prosperous ways before the decline in International finance which began 2007 and the rapid deflation of the Irish property bubble in 2008. The reassurances we are given by the big 2, AIB and Bank of Ireland and the Minister for Finance, Brian Lenihan, is that they are adequately capitalised and can absorb the level of debt they have been exposed to though their speculative dealings in the Irish property market.

But will they, after recapitialisation, be ‘good banks’, even if the government decides to help them further through a quarantining of the toxic assets? Even more importantly, will it be enough to get banks contributing to the economy again and thus aid its recovery?

In a new paper on the Tasc website Seán Ó’Riain illustrates how for the past 10 years, from when capital gains tax was cut to 20% in 1998 to 2007, lending by Irish banks increased by 466%. This, of course, contributed hugely to Ireland’s booming economy at the time, but as Seán demonstrates, the vast bulk of this was lent to the property sector with ‘construction, real estate development and housing finance’ accounting for the majority of the increase and ‘of the total lending by 2007′.

In contrast, however:

“…the high profile high tech sectors don’t get a look in. Despite rapid increases from a very low base in lending for R&D, lending to computer services firms remained a tiny proportion of lending and lending to hardware firms declined, as did the industry.

The effect of the tax cut was to increase speculative lending in real estate and finance relative to the productive long term investments needed in high tech sectors, which remained a tiny proportion of Irish investment.

[...]

While capital sloshed around, Irish banks did little to guide it toward the kinds of investments that would have supported medium and long term development.”

Even without the figures that Seán provides many people might say that this is now well known. However, that is far from the full story. What is perhaps more significant in the light of arguments about the efficacy of a stimulus plan is that Sean’s report demonstrates that government funds rather than following and supplementing existing private investment actually led that investment:

“In 1997 all investment was from domestic sources and one third of that was from the state. A significant portion of the remaining investment was stimulated by the state through ‘matching funds’ arrangements - perhaps up to an additional 25%. In 1998 domestic investment increased but more importantly international investors flooded into the increasingly successful Irish economy. The primary source of funds was private individuals as institutions such as pension funds, banks and insurance funds lagged behind. In 1999 however, institutional investors finally took the lead in funding. Non-European sources accounted for fully one third of funds in 1999, up from a quarter in 1998.”

By 1999 Ireland was well integrated into international institutional investment circles and the state withdrew from its previously dominant role as a source of funds. However, individual and institutional investors largely followed rather than lead the growth of the high tech industries in which most of this funding was concentrated.

Ironically, the risk taker here was the state. After the dot.com bubble burst in 2001, the state was crucial to the continuation and recovery of the venture capital sector.”

It is this sort of realism, of looking at exactly how money is invested in the economy, where it comes and where it goes to that is required if economic recovery is going to be possible. And it seems trusting the banks as they stand to figure out where best to invest money, as the government is currently doing, is not the best way of doing that. It assumes, first of all that the banks are interested in supporting medium and long term development and that their previous prosperity shows that the managers currently at the top of Irish banking are responsible for that. However, the increase in investment lending in Ireland had very little to do with the knowledge, skill or wisdom of bankers. Rather it was a case of capital looking for somewhere to go.

Paul Krugman explained this in a recent column which touched on why Ireland benefited so much in the late 90s from the glut in global capital that occurred with the movement of credit from Asian economies:

“In the mid-1990s,... Read article » the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States - hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.”

As has been pointed out in many other places that money is not coming back. However, this does not mean that future private investment will disappear. In his recent post on the progressive-economy blog Seán Ó’Riain points out that:

“Our growth cannot free ride on international trends as it did in the 1990s - it will have to be based on developing new capacities and forms of participation in the economy that keep people attached to the labour market through the recession, meet social and economic needs, and build capabilities that will serve us well when recovery comes. Fixing the financial system so that private investment is forthcoming will be an essential part of this process. Public investment - and therefore borrowing - will be crucial.”

So why are we not hearing more about the need to stimulating the economy? Michael Taft provides plenty of ideas below. Yet, there seems to be an economic argument against it although this is not fully explained elsewhere. One argument I have found against it that a stimulus package would come up against Ricardian equivalence, the idea that extra government spending will ‘crowd out’ private sector investment and this would render it either effectively useless or increase the cost of government borrowing while reducing the private sector’s ability to deal with the crisis.

Colm McCarty, writing in response to ICTU’s suggestion of a stimulus for Ireland, had this to say on the Irish Economy blog back in December:

“Any attempt by Government to stimulate will run up against Ricardian Equivalence anyway, even more so in the UK version, where the tax reductions are accompanied by specific commitments to increase taxes later. If the private sector is determined to improve its balance sheet through cutting consumption and investment spending, fiscal easing will either fail, in which case it is pointless, or ’succeed’ at the cost of frustrating the unavoidable private sector adjustment.”

There is more to McCarty’s argument than this, and even this is difficult to counter without knowing the theoretical basis of Ricardian Equivalence in detail - I’m not an economist - but a general untutored observation would be that this seems to suggest that private sector investment retracts or reacts negatively when government investment is provided.

And Ricardian Equivalence is, of course, a theory and a controversial one at that. Sean O’Riain’s paper, however, provides data which proves that when private sector capital dried up, after the bursting of the dot com bubble in 2001, that Irish state agencies provided the means for the venture capital sector to continue and to recover:

Professor Ó’Riain concludes:

“Table 4 shows that the bursting of the dot.com bubble was followed in 2001-2 with a drying up of almost all except the publicly provided funds and the continuing prominence of public funds in the recovery of venture capital investment as the decade went on. Given that much of the EI investment continues to be provided through mechanisms that encourage matched private investment, the majority of VC funding is publicly provided or stimulated, even if privately administered through a series of funds.

The public sector has been crucial to the provision of funds for investment in high tech and innovation, even as it competed with the rush of money to property and financial speculation induced by the tax decisions of its own government and administered by the banks that contributed relatively little to development.”

Both Paul Krugman and Willem Buiter have recently challenged the analysis provided by many macroeconomists who claim that a stimulus package is effectively useless. Indeed, both have said that the stimulus provided in both the US and the UK is not going to be enough. And finally, both have said that the idea behind recapitalization is wrong (and the latter has been highly critical of the Irish government’s approach to date) and that banks should be nationalized to ensure that capital is invested in the economy in an effective way.

In Ireland though we get the Ricardian Equivalence argument, and all alternative views are effectively blocked from the national media, while those who argue against a recovery plan based on stimulating growth are feted in the newspapers and given powers to apply those deflationary measures unquestioned.

It’s appropriate then for an economics ignoramus like me to pass over the final word to a Nobel Laureate in economics: 

“And as a result we have the spectacle of well-known economists offering what they think are profound arguments, but are actually long-refuted fallacies. Most important is the “Treasury view” that government spending can’t affect demand. But there’s also the astonishing belief that Ricardian equivalence means that consumer spending automatically falls to offset even a temporary increase in government spending, which seem to be part of that Poole quote. (New Keynesian models in which consumers fully anticipate future taxes still leave room for fiscal policy - but they don’t know that.)”