Ireland’s future depends on breaking free from bailout
IrishTimes Saturday May 7th. 2011
OPINION: Irelandis heading for bankruptcy, which would be catastrophic for a country thattrades on its reputation as a safe place to do business, writes MORGAN KELLY
WITHTHE Irish Government on track to owe a quarter of a trillion euro by 2014, aprolonged and chaotic national bankruptcy is becoming inevitable. By the timethe dust settles, Ireland’s last remaining asset, its reputation as a safeplace from which to conduct business, will have been destroyed.
Irelandis facing economic ruin.
Whilemost people would trace our ruin to to the bank guarantee of September 2008,the real error was in sticking with the guarantee long after it had becomeclear that the bank losses were insupportable. Brian Lenihan’s originaldecision to guarantee most of the bonds of Irish banks was a mistake, but amistake so obvious and so ridiculous that it could easily have been reversed.The ideal time to have reversed the bank guarantee was a few months later whenPatrick Honohan was appointed governor of the Central Bank and assumed de factocontrol of Irish economic policy.
Asa respected academic expert on banking crises, Honohan commanded theinternational authority to have announced that the guarantee had been made inhaste and with poor information, and would be replaced by a restructuring wherebonds in the banks would be swapped for shares.
Instead,Honohan seemed unperturbed by the possible scale of bank losses, repeatedly insistingthat they were “manageable”. Like most Irish economists of his generation, heappeared to believe that Ireland was still the export-driven powerhouse of the1990s, rather than the credit-fuelled Ponzi scheme it had become since 2000;and the banking crisis no worse than the, largely manufactured, governmentbudget crisis of the late 1980s.
Risingdismay at Honohan’s judgment crystallised into outright scepticism after anextraordinary interview with Bloomberg business news on May 28th last year. Havingoverseen the Central Bank’s “quite aggressive” stress tests of the Irish banks,he assured them that he would have “the two big banks, fixed by the end of theyear. I think it’s quite good news The banks are floating away from dependenceon the State and will be free standing”.
Honohan’smiscalculation of the bank losses has turned out to be the costliest mistakeever made by an Irish person. Armed with Honohan’s assurances that the banklosses were manageable, the Irish government confidently rode into the LittleBighorn and repaid the bank bondholders, even those who had not been guaranteedunder the original scheme. This suicidal policy culminated in the repayment ofmost of the outstanding bonds last September.
Disasterfollowed within weeks. Nobody would lend to Irish banks, so that the maturingbonds were repaid largely by emergency borrowing from the European CentralBank: by November the Irish banks already owed more than €60 billion. Despiteaggressive cuts in government spending, the certainty that bank losses wouldfar exceed Honohan’s estimates led financial markets to stop lending toIreland.
OnNovember 16th, European finance ministers urged Lenihan to accept a bailout tostop the panic spreading to Spain and Portugal, but he refused, arguing thatthe Irish government was funded until the following summer. Although attackedby the Irish media for this seemingly delusional behaviour, Lenihan, for once,was doing precisely the right thing. Behind Lenihan’s refusal lay the thinlyveiled threat that, unless given suitably generous terms, Ireland could holdhappily its breath for long enough that Spain and Portugal, who needed toborrow every month, would drown.
Atthis stage, with Lenihan looking set to exploit his strong negotiating positionto seek a bailout of the banks only, Honohan intervened. As well as beingIreland’s chief economic adviser, he also plays for the opposing team as amember of the council of the European Central Bank, whose decisions he is boundto carry out. In Frankfurt for the monthly meeting of the ECB on November 18th,Honohan announced on RTÉ Radio 1’s Morning Ireland that Ireland would need abailout of “tens of billions”.
Rarelyhas a finance minister been so deftly sliced off at the ankles by his centralbank governor. And so the Honohan Doctrine that bank losses could and should berepaid by Irish taxpayers ran its predictable course with the financialcollapse and international bailout of the Irish State.
Ireland’sLast Stand began less shambolically than you might expect. The IMF, whichbelieves that lenders should pay for their stupidity before it has to reachinto its pocket, presented the Irish with a plan to haircut €30 billion ofunguaranteed bonds by two-thirds on average. Lenihan was overjoyed, accordingto a source who was there, telling the IMF team: “You are Ireland’s salvation.”
Thedeal was torpedoed from an unexpected direction. At a conference call with theG7 finance ministers, the haircut was vetoed by US treasury secretary TimothyGeithner who, as his payment of $13 billion from government-owned AIG toGoldman Sachs showed, believes that bankers take priority over taxpayers. Theonly one to speak up for the Irish was UK chancellor George Osborne, butGeithner, as always, got his way. An instructive, if painful, lesson in theextent of US soft power, and in who our friends really are.
Thenegotiations went downhill from there. On one side was the European CentralBank, unabashedly representing Ireland’s creditors and insisting on fullrepayment of bank bonds. On the other was the IMF, arguing that Irish taxpayerswould be doing well to balance their government’s books, let alone repay thelosses of private banks. And the Irish? On the side of the ECB, naturally.
Inthe circumstances, the ECB walked away with everything it wanted. The IMF werescathing of the Irish performance, with one staffer describing the eagerness ofsome Irish negotiators to side with the ECB as displaying strong elements ofStockholm Syndrome.
Thebailout represents almost as much of a scandal for the IMF as it does forIreland. The IMF found itself outmanoeuvred by ECB negotiators, their lowopinion of whom they are not at pains to conceal. More importantly, the IMF wasforced by the obduracy of Geithner and the spinelessness, or worse, of theIrish to lend their imprimatur, and €30 billion of their capital, to a dealthat its negotiators privately admit will end in Irish bankruptcy. Lending toan insolvent state, which has no hope of reducing its debt enough to borrow inmarkets again, breaches the most fundamental rule of the IMF, and a heateddebate continues there over the legality of the Irish deal.
Sixmonths on, and with Irish government debt rated one notch above junk and therun on Irish banks starting to spread to household deposits, it might appearthat the Irish bailout of last November has already ended in abject failure. Onthe contrary, as far as its ECB architects are concerned, the bailout hasturned out to be an unqualified success.
Theone thing you need to understand about the Irish bailout is that it had nothingto do with repairing Ireland’s finances enough to allow the Irish Government tostart borrowing again in the bond markets at reasonable rates: what peopleordinarily think of a bailout as doing.
Thefinances of the Irish Government are like a bucket with a large hole in theform of the banking system. While any half-serious rescue would have focused onplugging this hole, the agreed bailout ostentatiously ignored the banks, exceptfor reiterating the ECB-Honohan view that their losses would be borne by Irishtaxpayers. Try to imagine the Bank of England’s insisting that Northern Rock berescued by Newcastle City Council and you have some idea of how seriously theECB expects the Irish bailout to work.
Instead,the sole purpose of the Irish bailout was to frighten the Spanish into linewith a vivid demonstration that EU rescues are not for the faint-hearted. Andthe ECB plan, so far anyway, has worked. Given a choice between being strung uplike Ireland – an object of international ridicule, paying exorbitant rates onbailout funds, its government ministers answerable to a Hungarian universitylecturer – or mending their ways, the Spanish have understandably chosen thelatter.
Butwhy was it necessary, or at least expedient, for the EU to force an economiccollapse on Ireland to frighten Spain? The answer goes back to a fundamental,and potentially fatal, flaw in the design of the euro zone: the lack of anymeans of dealing with large, insolvent banks.
Backwhen the euro was being planned in the mid-1990s, it never occurred to anyonethat cautious, stodgy banks like AIB and Bank of Ireland, run by faintly dimformer rugby players, could ever borrow tens of billions overseas, and lose itall on dodgy property loans. Had the collapse been limited to Irish banks, somesort of rescue deal might have been cobbled together; but a suspicion lingersthat many Spanish banks – which inflated a property bubble almost as exuberantas Ireland’s, but in the world’s ninth largest economy – are hiding losses aslarge as those that sank their Irish counterparts.
Uniquelyin the world, the European Central Bank has no central government standingbehind it that can levy taxes. To rescue a banking system as large as Spain’swould require a massive commitment of resources by European countries to aEuropean Monetary Fund: something so politically complex and financially costlythat it will only be considered in extremis, to avert the collapse of the eurozone. It is easiest for now for the ECB to keep its fingers crossed that Spainpulls through by itself, encouraged by the example made of the Irish.
Irishinsolvency is now less a matter of economics than of arithmetic. If everythinggoes according to plan, as it always does, Ireland’s government debt will top€190 billion by 2014, with another €45 billion in Nama and €35 billion in bankrecapitalisation, for a total of €270 billion, plus whatever losses the IrishCentral Bank has made on its emergency lending. Subtracting off the likelyvalue of the banks and Nama assets, Namawinelake (by far the best source on theIrish economy) reckons our final debt will be about €220 billion, and I thinkit will be closer to €250 billion, but these differences are immaterial: eitherway we are talking of a Government debt that is more than €120,000 per worker,or 60 per cent larger than GNP.
Economistshave a rule of thumb that once its national debt exceeds its national income, asmall economy is in danger of default (large economies, like Japan, can goconsiderably higher). Ireland is so far into the red zone that marginal changesin the bailout terms can make no difference: we are going to be in the Hudson.
TheECB applauded and lent Ireland the money to ensure that the banks that lent toAnglo and Nationwide be repaid, and now finds itself in the situation where, asa consequence, the banks that lent to the Irish Government are at risk oflosing most of what they lent. In other words, the Irish banking crisis hasbecome part of the larger European sovereign debt crisis.
Giventhe political paralysis in the EU, and a European Central Bank that sees itsmain task as placating the editors of German tabloids, the most likely outcomeof the European debt crisis is that, after two years or so to allow French andGerman banks to build up loss reserves, the insolvent economies will be forcedinto some sort of bankruptcy.
Makeno mistake: while government defaults are almost the normal state of affairs inplaces like Greece and Argentina, for a country like Ireland that trades on itsreputation as a safe place to do business, a bankruptcy would be catastrophic.Sovereign bankruptcies drag on for years as creditors hold out for betterterms, or sell to so-called vulture funds that engage in endless litigationoverseas to have national assets such as aircraft impounded in the hope thatthey can make a sufficient nuisance of themselves to be bought off.
Worsestill, a bankruptcy can do nothing to repair Ireland’s finances. Given theother commitments of the Irish State (to the banks, Nama, EU, ECB and IMF), fora bankruptcy to return government debt to a sustainable level, the holders ofregular government bonds will have to be more or less wiped out. Unfortunately,most Irish government bonds are held by Irish banks and insurance companies.
Inother words, we have embarked on a futile game of passing the parcel ofinsolvency: first from the banks to the Irish State, and next from the Stateback to the banks and insurance companies. The eventual outcome will likely seeIreland as some sort of EU protectorate, Europe’s answer to Puerto Rico.
Supposethat we did not want to follow our current path towards an ECB-directedbankruptcy and spiralling national ruin, is there anything we could do? WhileProf Honohan sportingly threw away our best cards last September, there stillis a way out that, while not painless, is considerably less painful than whatEurope has in mind for us.
Nationalsurvival requires that Ireland walk away from the bailout. This in turnrequires the Government to do two things: disengage from the banks, and bringits budget into balance immediately.
Firstthe banks. While the ECB does not want to rescue the Irish banks, it cannot letthem collapse either and start a wave of panic that sweeps across Europe. So,every time one of you expresses your approval of the Irish banks by moving yoursavings to a foreign-owned bank, the Irish bank goes and replaces your moneywith emergency borrowing from the ECB or the Irish Central Bank. Their currentborrowings are €160 billion.
Theoriginal bailout plan was that the loan portfolios of Irish banks would be soldoff to repay these borrowings. However, foreign banks know that many of theseloans, mortgages especially, will eventually default, and were not interested.As a result, the ECB finds itself with the Irish banks wedged uncomfortably farup its fundament, and no way of dislodging them.
Thisallows Ireland to walk away from the banking system by returning the Namaassets to the banks, and withdrawing its promissory notes in the banks. The ECBcan then learn the basic economic truth that if you lend €160 billion toinsolvent banks backed by an insolvent state, you are no longer a creditor: youare the owner. At some stage the ECB can take out an eraser and, where“Emergency Loan” is written in the accounts of Irish banks, write “Capital”instead. When it chooses to do so is its problem, not ours.
Ata stroke, the Irish Government can halve its debt to a survivable €110 billion.The ECB can do nothing to the Irish banks in retaliation without triggering acatastrophic panic in Spain and across the rest of Europe. The only way Europecan respond is by cutting off funding to the Irish Government.
Sothe second strand of national survival is to bring the Government budgetimmediately into balance. The reason for governments to run deficits inrecessions is to smooth out temporary dips in economic activity. However, ourcurrent slump is not temporary: Ireland bet everything that house prices wouldrise forever, and lost. To borrow so that senior civil servants like me cancontinue to enjoy salaries twice as much as our European counterparts makes nosense, macroeconomic or otherwise.
CuttingGovernment borrowing to zero immediately is not painless but it is the only wayof disentangling ourselves from the loan sharks who are intent on making anexample of us. In contrast, the new Government’s current policy of lying on theground with a begging bowl and hoping that someone takes pity on us does not makefor a particularly strong negotiating position. By bringing our budgetimmediately into balance, we focus attention on the fact that Ireland’sproblems stem almost entirely from the activities of six privately owned banks,while freeing ourselves to walk away from these poisonous institutions. Just asimportantly, it sends a signal to the rest of the world that Ireland – which 20years ago showed how a small country could drag itself out of poverty throughthe energy and hard work of its inhabitants, but has since fallen among thievesand their political fixers – is back and means business.
Ofcourse, we all know that this will never happen. Irish politicians are too usedto being rewarded by Brussels to start fighting against it, even if it is amatter of national survival. It is easier to be led along blindfold until thenoose is slipped around our necks and we are kicked through the trapdoor intobankruptcy.
Thedestruction wrought by the bankruptcy will not just be economic but political.Just as the Lenihan bailout destroyed Fianna Fáil, so the Noonan bankruptcywill destroy Fine Gael and Labour, leaving them as reviled and mistrusted astheir predecessors. And that will leave Ireland in the interesting situationwhere the economic crisis has chewed up and spat out all of the State’sconstitutional parties. The last election was reassuringly dull and predictablebut the next, after the trauma and chaos of the bankruptcy, will be anythingbut.