Contribution to 'What if Ireland Defaults?' book

The Keane report on distressed mortgages was a missed opportunity to face up to reality. Households are drowning in debt which is crushing our economy. This harsh reality will not disappear by ignoring it or putting it on the long finger. It can only be resolved by writing down mortgage debt across the board. We need to have an honest discussion about the levels of debt in Ireland. The central question that needs to be answered is this: How much debt is too much for the country to handle?

Central Bankers from across the world discussed the international debt crisis at a meeting in Wyoming in August. A keynote paper presented by Bank of International Settlement economists to the conference analysed the impact of the combined debt levels of governments, households and businesses on economic growth across a number of countries. It concluded that government debt in excess of 100% of national income damages growth; household debt in excess of 85% of national income damages growth and business debt in excess of 90% of national income damages growth.

These figures are striking because Ireland exceeds these levels for government, household and business debt. Government debt in Ireland stands at 137% of national income; household debt is 147% of national income and business debt is 210% of national income. The combined total for these three debt elements is 494% of national income.

The report continues by listing the combined debt €“ the sum of government, household and business debt €“ for eighteen developed countries. Ireland was not included on this list. However, the Department of Finance provided me with the Irish figures in a response to a Parliamentary Question. The debt league table is presented below, with the figure for Ireland included. This table really is quite shocking. It shows that combined debt levels in the Irish economy are almost twice those of the Greek economy. For every €1 billion of debt in the Greek economy, there is €1.8 billion in the Irish economy. If debt levels in Greece have reached the point that a sovereign default is imminent, what does this mean for Ireland and what should Ireland do about it?

It is even more disturbing to see that Ireland tops this league table ahead of Japan. Japan’s combined debt levels have flattened its economy to the point that the period since 1990 is frequently referred to as “the lost decades”. It is crystal clear that the current Irish combined debt levels will suffocate any chance of a robust economic recovery. It is clear that we must reduce our overall debt burden.

The high private debt levels in Ireland are very noteworthy. They place a limit on the amount of austerity that is possible. It is often commented that Irish public sector wages and social welfare rates are far too generous. Between them, they account for two in every three euro that the government spends. If we are to balance our budget through austerity alone, it is most likely that spending will have to be slashed in both of these areas.

To analyse the impact this will have on the economy, take the example of a family comprising of a Garda and a teacher with two children who bought a modest house in recent years. They are receiving wages that, by international comparisons, are very high. They are receiving child benefit that, by internal comparisons, is remarkably generous. The austerity approach is to slash public sector wages and social welfare spending, perhaps down to the Western European average. Out of context, this seems entirely reasonable. Why should European taxpayers provide us with cheap loans to pay social welfare benefits and wages at levels that they cannot afford? However, the impact that this would have on the family in this example must be considered.

Their take-home pay will be drastically reduced along with the income they receive in child benefit. This is likely to mean that they will be unable to meet the repayments on their mortgage. Their disposable income will shrink towards zero. Any discretionary spending they did will end immediately. When you consider that there will be a similar effect in every similar household in the country it is clear to see the economic collapse that would occur. The amount of bad loans in the banks would explode. The amount of spending in the economy would dry up to a trickle, forcing businesses to lay off staff or go out of existence. All of these consequences would cost the government more money. More mortgages in default will force the government to pump more money into the banks. More unemployment means that tax revenue will fall and social welfare expenditure will increase. This makes it impossible to balance the budget. This is the dilemma that Ireland is in. Without robust economic growth, we are stuck between a rock and a hard place. We need to balance our budget, but implementing austerity measures in the absence of robust economic growth is damaging our economy to the extent that it is impossible to balance the budget. Grafton Street is bustling every weekend. If we were to balance the budget this December, tax increases would be so penal and reductions in social welfare payments and public sector pay would be so crippling that few would have the cash to shop. Grafton Street would be empty of people and full of boarded up shops. Its atmosphere would resemble that of a ghost estate rather than a bustling city street.

The high private debt levels in Ireland place a definite limit on the amount of austerity that can be introduced. Once this point is passed, further austerity will simply cause more mortgages to become bad loans. This will force the government to provide further recapitalisation to the banks. This will put the country into a hopeless downward spiral. What proponents of endless austerity do not understand is that you cannot get blood out of a stone. There is a limit to the amount of austerity that an economy can take. We need to ask ourselves whether we have passed this point. Ireland’s budget deficit peaked at €23 billion in 2009. €21 billion of austerity measures have already been implemented. Despite this, our budget deficit is stuck at €15 billion, excluding the cost of the bank bailout. Clearly, austerity isn’t working.

The reason that austerity is taking place over a number of years is so that economic growth can return and lessen the impact of austerity. However, the domestic economy seems dead on its feet and will remain so until austerity ends. Exports are remarkably strong but our export partners are now facing very problematic economic problems of their own. If their demand for our goods dries up we are unlikely to experience any significant economic growth. Without robust economic growth, austerity simply will not work. Austerity will not work unless it is accompanied by a huge stimulus to the economy to keep money circulating around the economy. The most obvious source for this stimulus was the National Pension Reserve Fund. However, this has now been almost entirely emptied into dead banks. The only possible way to have a stimulus in the Irish economy is to write-down bank debts to the ECB and, in turn, pass these write-downs onto Irish households and businesses.

It is acknowledged that loan losses in the banks are in the order of €65 billion. Over the period of 18 months to earlier this year, while the scale of losses had been denied by the previous Government, the banks found themselves unable to repay in full the senior bondholders which were becoming due for repayment. Were it not for the ECB funding, the bondholders would have been largely wiped out. The ECB took a decision to protect the bondholders and loaned to the banks the €70 billion needed to redeem in full the bondholders. As the scale of losses became clear, deposits started to fly out of the banks. The combination of replacing deposits and repaying bondholders left the banks owing the European Central Bank and Irish Central Bank in excess of €140 billion. The scale of loan losses blew a hole in the banks’ balance sheets to such an extent that the banks could not repay their bondholders. Without ECB funding, the bondholders would have been largely wiped out. The ECB took the decision to protect the bondholders. Clearly, this was inappropriate and therefore we can say with justification that half the money owed by the banks to the European Central Bank and Irish Central Bank is odious debt. Through a political chain of events it has ended up on the backs of Irish citizens and this is patently unfair. In a nutshell, the senior bondholders have received a get out of jail card and the Irish citizen has been locked into an austerity jail. The ECB’s treatment of Ireland amounts to making Ireland the sacrificial lamb for European financial stability.

Many commentators believe that the Government’s hands are tied and that we must accept dictats from Frankfurt because we have no room for manoeuvre and no cards to play at the negotiation table. Nothing could be further from the truth. The European Central Bank has lent almost €100 billion to the Irish banking system. They did this to ensure that European banks could be repaid the full value of their bonds with interest. The collateral on this emergency funding can be removed. The Credit Institutions (Stabilisation) Act allows the Minister for Finance to force burden-sharing onto the European Central Bank. The ECB President was so disturbed by this Act that he signed off on a seven page opinion criticising the legislation.

By moving loans to a newly established bank, the Minister for Finance can remove the ECB’s collateral on emergency funding to Irish banks. This puts the Irish Government back in the driving seat. It allows for burden-sharing to be forced on the ECB and remaining senior bondholders, resulting in a realistic and workable resolution to Ireland’s banking crisis. In turn, it allows for write-downs on unsustainable mortgages, at no further expense to taxpayers, which would provide a vital boost to an economy suffering from years of austerity.

There is precedent for this. It is precisely the approach that Iceland took in dealing with its banking crisis, with the blessing of the IMF. Iceland moved banking loans to entirely new banks and wrote down the principal on mortgages by 30%. The bondholders were forced to pay for these write-downs. Moving Irish loans to new banks would effectively remove the ECB’s collateral and allow the Minister for Finance to force burden sharing on the ECB.

The ECB is reported to have forced the previous Irish Government into a bailout by threatening to cut off funding to the Irish banks. No other central bank in the world behaves like this. It is inconceivable that the Bank of England could bully the British Government like this or that the Federal Reserve could treat the American Government like this. The ECB have turned into an over-domineering Central Bank and need to be reined in. We should remind them that with a stroke of the Minister for Finance’s pen, their collateral on the funding to Irish banks collapses and their power over our country disappears.

Yields on Irish Government bonds fell by almost 40% since July 2011 as a result of Europe reversing its intention to charge Ireland the original draconian interest rate on its bailout loans. Forcing burden-sharing on the European Central Bank and passing this on to mortgage-holders through loan write-downs would have a far greater positive impact on Ireland’s solvency. If yields were to fall substantially again, Ireland would be very close to leaving the EU/IMF bailout and re-entering the markets. It’s time to challenge the ECB’s “no bondholder left behind” dogma. We must assert ourselves to defend our economy and protect our people.

Minister Noonan is quite right to continue raising bondholder burden-sharing with the ECB because it is no longer just an economic problem. It’s a political problem. The banking losses were incurred and should have been recognised long ago. The long loan loss denial was extremely damaging. Now, the crunch issue is who pays the bill. This is a political issue. It is unreasonable and wrong to expect the Irish public to pay the entirety of the bill for the bad investments of European banks. The Irish bank rescue will add at least 40 per cent of GDP to Ireland’s debt burden. To put this into scale, it’s the equivalent of expecting German taxpayers to provide over €1 trillion to foreign banks to protect their solvency. It’s the equivalent of French taxpayers paying over €800 billion to foreign banks to protect European financial stability. The German and French people wouldn’t tolerate this. They would insist on burden-sharing and write-downs. If the ECB doesn’t agree to a realistic and fair solution, we have to ask whether it’s time for Ireland to take firm action.

The European attitude to burden sharing with the private sector is schizophrenic. European leaders insist that purchasers of Greek Government bonds must face the consequences of their poor choice of investment. There will be a write-down of 50% on Greek government bonds. Speaking out of the other side of their mouth, European leaders insist that purchasers of Irish bank bonds must be protected from their poor choice of investment at all costs. Those who invested in an insolvent Greek state must share the pain whereas those who invested in insolvent Irish banks must be repaid in full with interest. There is no economic or moral logic to this whatsoever. The problem is not economic, it’s political. The Irish government is being forced, under duress, to repay the bank bonds because many European banks are a stable as a house of cards.

Banks increased the risks that they took with their customers’ savings in the hope of making more profit. If all the depositors of any bank in the world wanted to withdraw all their savings on one day, the bank would collapse. Banks do not have their customers’ savings. They have lent them out to make profits on loans. Banks do not retain their customers’ deposits in cash balances. They lend most of the deposits out by making loans to customers in order to make profits. In order to meet the normal calls by customers on their deposit accounts they retain a fraction of the overall deposits, called the fractional reserve and only lend out the balance. Over the centuries, banks established tried and tested prudential principles of fractional reserving at least 10% of their customers’ deposits and only lending, safely, the other 90%. Unfortunately, these rules were well and truly thrown out the window during the recent hyper credit bubble years and not just in Ireland.

Concern has been expressed by some observers at the levels of leverage by Germany’s Deutsche Bank and France’s Credit Agricole. In fact, they are leveraged to an even more dangerous level than Lehman Brothers was when it collapsed. It is worth pausing and reflecting on this point: French and German banks have been run as recklessly as Lehman’s Brothers. Numerous other French and German banks are in trouble to a lesser, but still very serious, extent. These are the banks that provided the funding to Irish banks to drown the Irish economy in debt. These are the banks that the Irish Government is forced to repay under duress every time it ensures that the bondholders in Irish banks are repaid in full.

Neither Germany or France are in a position to bail out their banks. The assets in Deutsche Bank are very questionable. They contain government debt that is likely to be written-down and loans that could go sour. Their assets are the equivalent of 80% of Germany’s GDP. German national debt is already close to damaging levels. It is very questionable to assert that the German government is capable of bailing out Deutsche Bank in the event of a crisis.

France’s situation is even more dire. Its three main banks have assets that are twice as large as the entire French economy. It is simply impossible for the French Government to bail out these banks. The French economy is just too small and their government debt is already at levels that are damaging to the French economy. The truth that Europe dares not speak is that there are Anglo-Irish type banks everywhere which could bring down their countries and the clock is ticking.

The German people and government are terrified that this crisis will lead to what they call “a transfer union”. This means that German taxpayers will provide annual transfers of cash to flathulach members of the Eurozone. However, the harsh reality is that the only transfer union that has been created is from Irish taxpayers to the worst behaved and most insolvent banks in the world. The Germans are adamant that solutions to the Eurozone crisis must not contain “moral hazard” €“ they must not reward countries or banks for bad behaviour. Surely the transfer union from Irish taxpayers to some of the world’s worst banks is moral hazard at its most extreme. This is law-of-the-jungle politics with every country fending for themselves. It is precisely the type of narrow-nationalism that the European Union was established to eradicate. The euro currency remains a worthy and worthwhile ambition but the tendency towards narrow-nationalism must end swiftly if the currency is to be saved. Realistic solutions must be found for all of the countries in difficulty.

The Irish economy needs two simple things to bring it back from the brink. We need a functioning bank and a huge stimulus to the economy. A functioning bank will provide credit to the economy and a huge stimulus will give people the encouragement that they need to start spending again. Standing up to Europe by enforcing write-downs on the amounts of money our banks owe the ECB and remaining senior bondholders across the banks will provide both of these medicines. Reckless lending by Irish banks only began this century. Moving the outstanding loans from the last century into a new bank will provide the first building block to a stable, functioning Irish bank. These assets are safe, secure and reliable. Writing down the odious debt to the ECB, and in turn, passing this write-down onto struggling mortgage holders and also to businesses under severe, unsustainable financial pressure will provide a huge stimulus to the economy. The cost to households of servicing loans will plummet allowing people to spend again and create jobs in the domestic economy.

Greece is on the brink of collapsing because its government debt levels are impossibly high. Ireland is on a slippery slope to becoming Greece. The Irish economy cannot take as much austerity as the Greek economy because our private debt levels are too high. The growth targets in the bailout programme are very ambitious and may not be achieved. This, combined with inevitable losses from the NAMA debacle later this decade, will force our government debt levels to unsustainable levels and we will end up in a similar position to Greece with a high probability of default. This would be a tragedy. Instead of defaulting on bank debt for which the State bears no responsibility, we would have a sovereign debt default that would damage our international reputation for decades.

At 494% of national income, Irish combined debt levels are the most crushing in the world. We must resist being forced to bear impossible levels of debt overhang which expert economists have shown to be the main cause of contraction and stagnation in an economy. We must insist on write-downs totalling around €75 billion on amounts due to the European Central Bank and outstanding bondholders across the banks. These write-downs must in turn be passed onto households and businesses. This would provide a huge stimulus to the economy. Write-downs of €75 billion may appear large and suggest that Ireland in some way is being let off the hook. This is far from the case. It would result in Ireland moving only one place down the league table, putting us just one place below Japan. We would still be carrying a huge load but at least it would be somewhat more manageable than where we stand at present. We must insist on putting this case forward to the ECB and unilateral action must not be ruled out if a sensible, workable, realistic agreement cannot be reached.

Peter Mathews (BComm, MBA, AITI, FCA) is a Chartered Accountant and Banking and Finance Analyst.

Country Total Debt as Percentage of National Income %
 

Ireland 494
Japan 456
Portugal 363
Spain 355
Denmark 341
Sweden 340
Norway 334
Belgium 328
Netherlands 327
UK 322
France 321
Canada 313
Italy 310
Greece 273
Finland 270
USA 268
Germany 241
Austria 238
Australia 232