Ireland’s fiscal crisis is largely caused by the collapse of the house price bubble and over-reliance on revenues from construction-related activities. This is bad enough, but by itself it would be difficult but manageable. The millstone around the neck of the Irish people is the vast scale of the crisis in the banking sector. Ireland’s banking crisis is not primarily about complicated and risky financial products: it is a common-or-garden result of reckless lending for property development and an inadequate regulatory regime. Between 2004 and 2007, the banks had escalated the scale of their lending to construction and property development enormously. When financial meltdown was imminent in September 2008, the government undertook to guarantee all of the banks’ losses, bondholders as well as depositors. In what is now widely regarded as a terrible mistake, the government in effect socialized the enormous private debt of the banks.
The true picture of what is entailed has been slow to emerge. The government’s attempts to shore up the banks have not involved outright nationalization, but the creation of a National Asset Management Agency (NAMA) to transfer the bulk of the banks’ non-performing property-backed loans into a special purchase vehicle, at a discounted rate. This amounts to indirect recapitalization of the banks. The total cost of Nama-type loan loss is now estimated at €66 billion. This is, in effect, half of GNP (the best measure of the taxable resource base of the Irish economy), which in 2009 amounted to €131.2bn. Mortgage and personal loan losses have not yet come fully into focus, but may amount to an additional €25 billion.
The present government, a coalition between the dominant centre-right Fianna Fáil and the Green Party, must go to the polls soon, and they will certainly be trounced. But unpopular though it is, the government was adamant until almost the last moment that it did not need or ask for the rescue package. Borrowing needs were fully met until mid-2011, and government had no need to go back to the bond markets. ECB as well as European Commission representatives had been on an extended visit to the Department of Finance, inspecting plans for the budget due on 7 December, in line with the strengthened fiscal oversight practices in the Eurozone. EU Commissioner for Economic and Monetary Affairs Olli Rehn had declared himself happy with the plans he had seen. Austerity measures were projected to take some €4bn out of the economy as part of the planned fiscal consolidation strategy. This was intended to ensure conformity with the Stability and Growth Pact requirements of 3% deficit by 2014.
Yet Ireland is now committed to an IMF-EU rescue package worth €85bn over the coming years, to fund both government spending and to support the costs of sorting out the crisis in the banks. It all happened very quickly, and indeed one government minister said they were bounced into it. The terms are set out in the government’s new four-year fiscal plan. The interest rate involved is not low, at an average of 5.87%. The total fiscal contraction will come to €15bn, though the deadline is now extended until 2015. The December budget alone will take out €6bn in a mix of spending cuts and tax increases. This is tougher than anything that had been envisaged so far. In addition, the National Pension Reserve Fund, a rainy-day measure set against future public pension liabilities, is to be used as part of the bail-out package. Most controversially from the point of view of Irish taxpayers, while these public assets are to be committed to the front line of bank recapitalization, the banks’ bondholders are not to be required to bear any losses. The most equitable adjustment measure, from the point of view of the Irish taxpayers, would have required some element of writing down outstanding debt through an orderly restructuring, that is, burning the bondholders. But this could damage government’s capacity to raise future funds through borrowing; government ministers stress that they really had no option in this. Yet there is palpable anger in Ireland at the outcome which ensures that the banks will be bailed out while the cost is to be borne in full by the taxpayers.
Kevin O’Rourke has put out a beautifully written, heartfelt piece on Ireland’s woes. Read it and weep.
Update: Gah — we seem to have overwhelmed the hamsters at Eurointelligence. I’m going to put O’Rourke’s text under the fold for the time being.
Letter from Dublin
It is one thing to know that someone you love is terminally ill; their death still comes as a shock.
I certainly don’t want to compare the arrival of the EU-IMF team in Dublin last week to a bereavement. But I was surprised at how upsetting I found it, given that it came as no surprise. It had been clear for a long time that the blanket guarantee given to the liabilities of Ireland’s rotten banks, in September 2008, had saddled the State with a debt that was too big for it to handle. Ten successive quarters of declining real GNP, and one attempt too many to draw a line under the losses of our banks, made our exclusion from international capital markets inevitable. But to know something is one thing; to see it actually happen is something entirely different.
I am not alone in feeling this way, it seems. The economics editor of the Irish Times, Dan O’Brien, wrote that
nothing quite symbolised this State’s loss of sovereignty than the press conference at which the ECB man spoke along with two IMF men and a European Commission official. It was held in the Government press centre beneath the Taoiseach’s office. I am a xenophile and cosmopolitan by nature, but to see foreign technocrats take over the very heart of the apparatus of this State to tell the media how the State will be run into the foreseeable future caused a sickening feeling in the pit of my stomach.
This is not to say that we would be happy to have our country’s affairs managed by the current, disgraced, government. I yield to no-one in my loathing of the men and women who have done this to my country. What has been the intellectual low-point of the last couple of years? Was it the cash-for-clunkers stimulus package (Ireland does not produce any cars)? Or the statement by our Finance Minister that Ireland need not fear a bank run, since Ireland is an island? Or the biggest Irish joke of them all, which underpinned the bank guarantee in the first place: that if we wanted investors to retain confidence in the creditworthiness of the Irish State, we needed to make sure that nobody who invested in our (private sector) banks ever lost a penny?
The latter decision is the one that sank the country. It was the last great act of hubris of the Celtic Bubble, and was immediately denounced by one of the heroes of the crisis, my old UCD colleague Morgan Kelly. On the night the guarantee was announced, Kelly pointed out that while it was the right policy if the Irish banks were facing a liquidity crisis, it was a terrible policy if they were insolvent, which was in fact the case. As they always do when confronted with someone smarter than them, the Dublin establishment circled the wagons, and Kelly was dismissed as an irresponsible young troublemaker of no consequence. He has been proved right, of course, but the establishment is still at it, making the
same fundamental mistake of thinking that a solvency crisis is just a liquidity crisis. Now, however, the establishment is European as well as Irish, and it is the State rather than the banking sector which is insolvent.
David Gardner draws my attention to this Letter from Dublin by Kevin O’Rourke, one of Ireland’s most distinguished economists. It might be the best single thing I’ve read on the Irish crisis. Analytically astute, and moving too. Just how profound a blow this has been comes through. It is not just an economic and political crisis, but a full-blown constitutional crisis. And the European Union has made it all so much worse than it needed to be.
The Irish “rescue package” finalized over the weekend is a disaster. You can say one thing for the European Commission, the ECB and the German government: they never miss an opportunity to make things worse.
It pains me to say this. I’m probably the most pro-euro economist on my side of the Atlantic. Not because I think the euro area is the perfect monetary union, but because I have always thought that a Europe of scores of national currencies would be even less stable. I’m also a believer in the larger European project. But given this abject failure of European and German leadership, I am going to have to rethink my position.
The Irish “program” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130 per cent of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan. After a couple of years, not just interest but also principal is supposed to begin to be repaid. Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.
This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor. Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?
As a resident of California, I have some advice for the EU: something good is really unlikely to turn up. Kicking the can down the road just makes the can mad. Like it or not, you’re better off dealing with this stuff sooner rather than later.
There’s no question that it is morally outrageous for taxpayers who had nothing to do with the overlending to be saddled with the costs, while bondholders who should have watched where they put their money, walk away scot free. Moreover, I cannot but believe that this is creating considerable moral hazard; investing in bank debt starts to look something like investing in the sovereign debt of the country where the bank is.And yet it seems to me that the practical question remains: is Ireland actually better off if it does this? Are the taxpayers? Couldn’t the contagion get worse? We’re talking about a country that has been the net recipient of a lot of foreign capital over the years (which is why, in part, the Irish are so outraged.) The government is running a sizeable primary deficit, and as far as I can tell, expects to for at least a couple of years. If telling the bondholders to take a haircut triggered capital flight, wouldn’t that mean dramatic austerity right now, as the government was suddenly forced to balance its books? What about the contraction of household credit?I’m asking the question, not answering it: I genuinely don’t know. The EU could have backstopped Ireland’s government spending without a guarantee for the bondholders, of course. Probably, they should have. But was that very likely to happen? These are countries where the banks are “too big to save”–where the bank liabilities are twice GDP, or even higher. They’re very wary of anything that makes their financial sector even slightly less sound.Have there been any really successful situations where the bank bondholders were not made whole? Again, I’m asking, not answering; I would feel a lot better about saying Ireland should take this course if I knew of instances where it had been successfully pulled off in the past. As far as I can tell, even famously “tough” solutions like the Swedish nationalization ultimately made the bondholders whole, as the FDIC does in our own country. The logic is simple: a run on bank bonds looks like a slow-motion run on the banks.To be clear, I am not arguing that bailing out the bondholders at taxpayer expense is right or fair; it is not right, and it is monstrously unfair. I am only arguing that doing the fair and right thing, and making the bondholders eat the losses instead of the taxpayer, might end up costing taxpayers even more. For example, I’d argue that whatever it might have cost taxpayers to prop up all the banks in 1929, that burden would have been infinitely preferable to the Great Depression.
I guess we can find some small comfort in the fact that another country is doing it even more wrong.