Counting Not The Cost Thereof

Lenihan taking a gamble but it’s only a small one – Analysis, Opinion –

The question is, will the loans be worth €54bn in 10 years’ time? If they are, there is no cost to the taxpayer. If they are not, there will be a cost. If they should turn out to be worth more, the taxpayer will gain. It may not, however, be the most important question.

I don’t get into the mechanics of economics on this blog, because I’m very conservative about how much I actually know about them. But if I take the fire extinguisher to the burning wheelie bins of my mind for a moment and attempt to recall one of the first things I learnt in economics class, the matter of opportunity cost looms rather large reading the above sentences.

A good illustration of opportunity cost comes from this example by libertarian economist Tyler Cowen, of the man who spent one year in the business of trading one red paperclip for a house.

Kyle traded his way up through a fish pen, a Coleman stove, a generator, a snowmobile, a van, one year’s free rent in Phoenix, an afternoon with rock star Alice Cooper, and finally to the house, one year later.

That sounds impressive, but was it worth the time and trouble? The answer is yes, but not for the reasons we might think.

Judging from the local real estate market, Kyle’s house is worth about $50,000. Why didn’t Kyle just go out and buy a house? Surely such a smart and able person could have spent the year working at a good job. Even if Kyle would not have earned much his first year, he would, over time, likely attain a much higher wage. A good floor trader on a commodities exchange can become a millionaire. A good salesman can, on commission, earn more than a company president. The cost of Kyle’s trading is not what he could have earned his first year, but rather what he could have earned in that one missing year from the latter part of his career. I’ll hazard a guess that is more than $100,000, or in other words, more than the value of the house.

So, with regard to NAMA, even if the loans are worth more than €54bn in 10 years’ time, following the logic of opportunity cost, that does not mean that there is no cost to the taxpayer, since the cost to the taxpayer really ought to be measured in terms of what could have been done with that €54bn during the ten year period. I will leave the calculations of how that €54bn could otherwise have been used up to you.

But, with regard to NAMA, why focus on the taxpayer? Joan Burton was on the radio yesterday talking about how the Labour party’s interest was in protecting the taxpayer. It was as though the function of government were that of a private investment agency and the taxpayer’s role that of the investor, which I suppose is not so surprising in a place where the notion of the country as an incorporated enterprise -Ireland Inc- is commonplace among politicians and media. There are lots of problems with this paradigm, not least the fact that there are lots of citizens who would not fall under the rubric of ‘taxpayer’, but who will nonetheless be directly affected by the decision to fork out €54bn on property loans. Most of them are under 18, and a substantial number of them aren’t born yet. Perhaps their economics teachers will point to their dilapidated schools as an illustration of the concept of opportunity cost.


4 Responses to “Counting Not The Cost Thereof”

  1. 1 Longman Oz September 17, 2009 at 9:20 am

    Sorry to be contrary for two days running. I probably am the kind of reader who tacitly agrees and vocally disagrees…

    I had been going to make a point about Kyle’s house acquisition being supplemented by income from an international book deal. However, this is what the author was ultimately driving at in his article, so it is worth clicking through to. Anyway, it is neither here nor there. I appreciate the point that you are getting at, which is the major investment consideration of opportunity cost!

    This, then, brings me onto NAMA. There is an important technical point here in terms of cash flow. Essentially, the banks are going to swap their dodgy loans for NAMA bonds. This is a paper transaction only, i.e. no actual cash exchanges hands. Hence, the government is not borrowing cash that it then spends. Rather it is acquiring assets (i.e. mostly mortgage loans) in return for IOUs given to the banks involved in the scheme. Moreover, the theory is that these assets are/will be sufficient generators of cash that they will provide the government with enough money to service interest on the IOUs and eventually repay them in full. Hence, if all goes swimmingly, actual taxpayer money will never be called upon.

    Of course, this is why so much attention has been paid to the whole area of valuation and whether these assets can achieve this ambition or will the taxpayer end up footing a bill for the shortfall (which current is at least €7 billion, assuming the figure of €47 billion of current market value to be a reasonable one… probably a very big assumption, if the likes of Morgan Kelly is to be believed).

    As a result, the only way that it could cost the taxpayer €54 billion would be if the value of the acquired assets fell to zero (leaving the cost of interest payments to one side, for the sake of simplicity). Equally, though, you would be damn foolish not to expect some shortfall to arise. Hence, this is why NAMA, without a chunky mitigating consideration such as nationalisation, seems like such a bad deal.

    I do like your point on the narrowness of the term “taxpayer” though when it comes to impact… especially from the likes of a senior Labour Party figure!

  2. 2 Hugh Green September 17, 2009 at 9:54 am

    I appreciate the important point you’re making: that it isn’t a question of spending €54bn, but of acquiring €54bn worth of ‘assets’ (some of which are unlikely to be assets at all, but liabilities), and therefore the opportunity cost is not a question of how €54bn might otherwise be spent, but the opportunity foregone through acquiring and managing the assets in the first instance.

    In terms of Cowen’s piece, yes, he demonstrates that in the end the calculation of the opportunity cost isn’t as simple as what ‘he could have earned his first year, but rather what he could have earned in that one missing year from the latter part of his career’, but in any particular case is determined by wider range of considerations. However, I thought the initial example he gave was reasonably instructive as a means of understanding how opportunity cost is applied.

  3. 3 coc September 17, 2009 at 11:50 am

    There is an important technical point here in terms of cash flow. Essentially, the banks are going to swap their dodgy loans for NAMA bonds. This is a paper transaction only, i.e. no actual cash exchanges hands. Hence, the government is not borrowing cash that it then spends. Rather it is acquiring assets (i.e. mostly mortgage loans) in return for IOUs given to the banks involved in the scheme.

    As I understand it, the government are issuing €54bn worth of IOUs redeemable by the banks for cash by the ECB. Those IOUs are bonds and Lenny explained on the wireless this morning that they were 6 month bonds at a rate of ECB +.5%. There is another way of saying ‘issued €54bn worth of bonds’ and it is ‘borrowed €54bn’. This borrowing goes straight onto the national debt. Lenny made much of the low interest rate but had no real answer to what happen when the interest rate increases (as the whole world knows it will).

    Effectively then, the State has taken out a humongous tracker mortgage on the assumption that the assets will appreciate sufficiently quickly that the repayment schedule doesn’t bleed us dry. Is that not precisely the calculation that middle Ireland made over the last decade, with disasterous consequences?

    Cue the finanacial regulator ad “I don’t know what a tracker mortgage is”, to which the appropriate answer is (with hindsight) “you lucky b*stard!”.

    The whole scam is madness. Utter madness.

  4. 4 Longman Oz September 17, 2009 at 12:41 pm

    Not quite the case COC – I am afraid that you are falling for some Fianna Fail spin that NAMA is essentially an ECB-backed structure. Brian Lucey and Karl Whelan over on can explain this way better, but I will give it a quick go anyway…

    (1) AFAIK, there is no requirement in the legislation that compels the banks to do anything with the bonds that they acquire from NAMA.

    (2) The ECB will never, ever purchase these NAMA bonds from the banks.

    (3) Where the ECB will most likely come into this is that, as a central bank, it provides short-term liquidty funding to the banks in the Eurozone. Since the crisis of last year, though, this has taken the sizeable and irregular form of life-support for the Irish banks because everyone else has been afraid to lend to them in the money markets.

    At the same time, in order to get this funding, the banks need to provide the ECB with specific forms of collateral.

    Accordingly, the NAMA bonds will presumably be designed to be short-term pieces of paper that match all of these specific requirements and which will need to be refinanced every 6-12 months (I think).

    However, it is by borrowing in this manner from the ECB, that the banks will get the money to perhaps re-stimulate the economy or, more likely, if you ask me, pay down the huge overhang of bond funding that they used to fuel their decade-long property splurge in the first place.

    If the banks fail to repay the ECB, they are still fully liable for what they borrowed, but the ECB could also then use the bonds as a means of getting repaid. If these bonds are insufficient for it to be repaid, it could, in theory, seek the winding up of the bank or banks in question.

    (4) Anyway, to the best of my knowledge, the NAMA bonds will not be added directly to the national debt (at least from the relevant accountancy perspective… zzzzzz!). However, we are definitely at risk if there is a shortfall, as I mention above.

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