Irish interest spreads did not fall and contagion continues. Here one of the world’s leading international economists explains why. Short-sighted, wishful thinking by EU and German leadership designed a package that is not economically feasible in the long run (it would trigger a vicious debt deflation spiral) and it is not politically sustainable in the short run. The Eurozone had better have a Plan B for when the new Irish government rejects the package next year and imposes a haircut on Irish bank bondholders.
The Irish “rescue package” finalised 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 Eurozone 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 grand European project. But given this weekend’s abject failure of EU and German leadership, I am going to have to rethink my position.
A solvency problem postponed is a problem made intractable
The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% 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.
According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.
The inevitable populist backlash
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?
Infeasibility of a wage-cutting exit plan
Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in “internal devaluation” because the traditional option of external devaluation is not available to a country that lacks its own national currency.
But the more successful it is at reducing wages and costs, the heavier will be its inherited debt load. Public spending then has to be cut even more deeply. Taxes have to rise even higher to service the debt of the government and its wards such as the banks.
This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of “debt deflation” about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.
What should have been done
For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. This would have been particularly easy in the Irish case.
A bright red line could have been drawn between the third of the government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other hand.
The third representing the debts of the Irish banking system could have been restructured.
Bondholders could have been offered 20 cents on the euro, assuming that the Irish banks still have some residual economic value.
If those banks are insolvent, the bondholders could – and should – have been wiped out.
Irish public debt would then have topped out at maybe 100% of GDP. And the Irish programme would have had a hope of working. As it is, the programme will have to be revisited, perhaps as soon as next year. Investors know this, which is why Irish spreads have barely budged.
In fact, this is exactly the policy that the IMF, which at least knows how to add, has been pushing for over the last week. But the Fund was unable to overcome the objections of the Commission, the ECB, and the German government.
Why the mistakes?
One can interpret the intransigence of the German government and its EU allies in two ways.
First, they understand neither economics nor politics. As Tallyrand said of the Bourbons, “They have learned nothing, and they have forgotten nothing.”
Second, policymakers in Germany – and in France and Britain – are scared to death over what Ireland restructuring its bank debt would do to their own banking systems.
If the second interpretation is correct, the appropriate response is not to lend to Ireland – to pile yet more debt on the country’s existing debt – but to properly capitalise the French, German, and British banking systems so that they can withstand the inevitable Irish restructuring.
But European officials are scared to death not just by their banks but by their public who don’t want to hear that public money is required for bank recapitalisation. It’s safer, in their view, to kick the can down the road in the hope that something good will turn up – to rely on “the luck of the Irish.”
As John Maynard Keynes – who knew about matters like reparations – once said, leadership involves “ruthless truth telling.” In Europe today, as recent events make clear, such leadership is in short supply.
Editor’s note: This piece was first posted in German on Handelsbatt’s blog and reposted first in English by Kevin O’Rourke on the Irish Economy blog. Republished from voxeu.org
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With a lot of respect for Eichengreen for his usual work, but this stuff here is shallow, uninformed nonsense. Firstly, it totally ignores the role of the IRISH goverment in this. They are responsible for the deregulation that led to their bubble, and they annoyed other European nations with their “beggar thy neighbor” corporate tax discount rate policy, hijacking corps that had made big profits in other EU nations. That resulted in applause by the US, but certainly not in much sympathy from their neighbors. Consequentially, they couldn’t expect too much, if any, generosity in the negotiations.
But they still could get a better deal. They only had to accept a compromise about their unfair coriporate tax issue. But they refused to raise this. And the damaging budget cuts are their won repsonsibility, too. They could have offered other ideas. They didn’t. This whole part is missing from Eichengreen’s account!
Instead, we find lots of brouhaha about the alegedly dominating role Germany plays in Europe. Anyone even passably informed about EU politics knows that utter nonsense. Of course, Germany has SOME influence, after all, about 1/6th of the European population is German. But we don’t call the shots in any way, and have less leverage than France. Let’s not forget, most of the Eurocrats in Brussels speak French! We don’t even “control” the ECB. Firstly, the Euro was an idea by, you guess it, France, which Germany had to accept as part of the deal for the reunification. That’s why Germany abandoned the DM, even though the vast majority of our population was against it!
And German influence on the ECB has always been limited by other nations who were suspicious of the strict GErman monetary policy. This went so far as to the ECB rejecting German pleas for a weaker Euro in the early naughts, because the Spanish, a much smaller nation, had inflation problems (because of the bubble building up there). So, no German domination at all. Only when there are questions of paying for European issues, we have a stronger say. But that’s because so many others aqre net receivers, not payers! And imho even Barry Eichengreen should have some understanding for Germany not simply throwing its taxpayers money with both hands out of the window, but demanding accountability and responsible policies in return! The US don’t give away anything for nothing, either.
There’s much more I could write abit this stupid hit piece, but enough already. It should be obvious that Eichengreen was writing about stuff that’s way beyond his area of expertise, about European politics instead of US economics. A European prof of political sciences probably would give him a D or E for this sloppy work!
Well, I am German as well and I think you are wrong on most accounts. The bit that is true is about the Irish corporate tax rate. But this is hardly new. It has been a beggar thy neighbour policy for years and nobody seemed to be fussed about this. In the current Irish crisis there are a few simple truths:
- The Irish are insolvent and a new credit line by the EU/IMF won't solve the issue. A haircut/default is the only solution. The debt must come down and the creditors have to suffer losses.
- This would also put the blame where the blame is due: the banks that bought those bonds under given circumstances. If this means British and German banks are fucked so be it. Let's rather deal with this than innocent taxpayers in Ireland paying for decades for foreign banks. The banks bought papers that offered high returns and they were happy to take the profits. But if it all goes pear-shaped the general public pays? That's just not right! That's the worst of capitalism and the worst of socialism at the same time!
So stop blaming people for voicing their opinions. We need to sort this mess out and we need to sort it out now! If not we will face political extremism unheard of in decades.
"A haircut/default is the only solution"
I don't necessarily disagree. But it's the Irish government in the first place which has to implement this! I don't see any willingness in the Irish administration to go that way.
"If this means British and German banks are fucked so be it"
Woudl still probably be chaeper to only bail out our won banks instead of the PIIGS! But what kind fo Europeans would we be if we would follow that selfish path?
"So stop blaming people for voicing their opinions."
You want to stop me voicing my opinion because it happens to be opposed to that of other ones? Excuse me pls, but don't you see the logical falacy in this?
Apart from this, what I protest here, and rightly so, imho, are Experts who weigh in as they are authorities on the issue, but who show in every other sentence that their view are based on cheap stereotypes and talking points that bear no resemblance to reality! And will contue to do so. The discussion about the right5 course for the EU is too important to be based on anything else but FACTS. Eichengreen doesn't have any, only totally subjective and uninformed views. That's not helpful at all.
Indeed, the author has given Barry Eichengreen on the key issues of Irish economic problem:
1. Economic and political unsustainability of the adjustment plan proposed by the European Union and the IMF to the Irish government.
2. The terrible fear with other EU governments, especially the German, since the alternative of dropping the Irish bad banks poses serious problems for the German banking system, no doubt.
Economists who analyze the economy constantly suspect that the German financial system’s health is worse than the government says. Some German banks have received significant capital injections from the German government. So a default by the Irish banks, he has a huge problem.
On the other hand, if we proceed to the suspension by Ireland, with the risk on the German economy poses a serious problem for the other EU partners.
So we have a serious problem on the future of our economy, regardless of the EU country where we live.
Keep in mind that Ireland has only 10 million inhabitants and its GDP represents a very small percentage of EU GDP. However, the excessive size of its banking system and some measures of his administration have made the problem was huge.
Specifically, the fact that his government would guarantee all deposits, and all debts of its banks, has made private debts are made public in a matter of minutes. Now it seems that the banks’ debts arising mainly from risk and unsafe practices, they move to the liabilities of the public.
Possible solutions:
No doubt a good part of the solution passes through a reduction of public expenditure in Ireland. That his government has limited the salaries of public officials to 250,000 euros per year, it seems an aberration, since it is a huge amount a poor country can not afford. His government would have to limit those salaries more. It’s just a small detail in a myriad of problems in public spending.
On the other hand, one should think that at least part of the debts incurred by banks with foreign investors, perhaps it should not be returned. It is an agreement to do the governments of the EU and the IMF, together with the Government of Ireland.
Maybe, just maybe, the extent of Iceland to drop to its banks, it has been such a bad situation. Iceland is currently out of recession and growing and positive rates. Two or three banks have less, but people have jobs.
Manuel Caraballo Callero
Spanish Economist
http://manuelcaraballo.wordpress.com