Time to persuade Europe debt write-down is needed

 Ireland has to convince the ECB to share the burden imposed on taxpayers – even if it means considering a unilateral decision....

By BRIAN LUCEY 
Irish Times http://www.irishtimes.com/newspaper/opinion/2011/0215/1224289816780.html

I RECENTLY had coffee with a former colleague who is now working in the financial services industry in Germany. He was at pains to stress that the general tenor of the German press, even among the tabloids, was that although Ireland had been stupid, feckless, and perhaps somewhat arrogant, it was in general a well-run European country that was at least trying, painfully, to get out of the hole it had in part dug for itself. He felt there was a degree of sympathy for the Irish, and the German taxpayer would understand if the Irish, having made a genuine effort, required the European partners to take some of the burden.

While anecdotal, this reflects the fact that at heart our European partners, certainly at individual level, are fair and decent people. Two and a half years into this catastrophic banking crisis, it is clear that there have been sequential policy failures at European and domestic level.

At domestic level, the litany of failure is too long and dismal to reiterate. At European level, it is clear that the decision not to allow the Government, even as late as the second half of 2010, to impose losses on senior bondholders has resulted in the European Central Bank (ECB) becoming more deeply entangled in the Irish banking crisis than was thought possible.

The ECB has in excess of €100 billion extended to domestic banks. The Irish Central Bank has extended more than €50 billion. The only reason money flows from ATMs is that it is being provided by the ECB.

The decision by the ECB – and although this has never been explicitly articulated it has never been denied – appears to have been a quid pro quo. In return for the Irish authorities not imposing losses on senior bondholders, the ECB would continue to fund Irish banks.

The consequence of splitting the liquidity problem, being solved by the ECB, from solvency problem, being fixed by the Irish taxpayer shovelling untold tens of billions of euro into banking black holes, is that the two problems have become entwined.

Irish banks cannot get liquidity from international markets because they are fundamentally insolvent. Until this is solved, the system is stuck – see the analysis on this by Arthur Beesley in yesterday’s Irish Times .

Above and beyond all this lies the fact that at its heart the euro is a political, rather than an economic, experiment. Any solution must therefore also lie in politics. It is generally agreed that the terms and conditions of the bailout, in particular that part of it emanating from our European partners, are such as to make it incredibly difficult for the State to avoid significant and unnecessary cuts.

We must therefore negotiate a political solution to the banking crisis, and this must involve the writing down not just of the interest rate we pay on the bailout, but the actual amount of money we are borrowing.

Recent research by Reuters has indicated that changing interest rates over the period during which the bailout is drawn down will not have significant effects on the overall debt/income dynamics. All research indicates that the fundamental drivers of sovereign interest rates are domestic fiscal imbalances.

Freed from the burden of having to adjust our tax and spend not just for fiscal imbalances but also to pay the private debts of bankers, the State can much more quickly find itself moving towards long-term financial stability.

Very crudely, if one-third of the bailout is for the banks, then one-third of the adjustment per annum can be seen as going not towards reduction of our fiscal deficit but to paying off these private debts.

Using the same ratios to get our fiscal house in order will result in Ireland being able to return to the international capital markets with a cleaned up national balance sheet much sooner than is expected.

In the political negotiations that will have to take place in the coming months, we have to remember that we are not powerless. Negotiation is about give and take. If we are asking our European partners to write down some of our debts, the part we foolishly took on from private debt holders, what are we bringing to the table? It is very clear that there is no question of our 12.5 per cent corporate tax rate being up for discussion. There are other ideas which we cannot carry through.

For example, Fine Gael has floated the idea of borrowing not from the ECB but from the US Federal Reserve. This would expose the ECB as being utterly unable to keep its house in order, with deleterious consequences for the euro.

Or there is the alternative being proposed that we unilaterally impose losses on senior bondholders. Another alternative is that the Minister for Finance – and we do still have one – actually exercises the powers which he has belatedly acquired.

We see with Anglo and Irish Nationwide that the proposal is in effect to hollow these banks out, transferring their deposits and leaving the senior bondholders with the remaining carcass. There is no reason in principle that this could not be done to other banks.

The problem from the ECB’s perspective is that this would give a clear signal to the overleveraged European banks, and to the pension fund and long-term investors who purchased the senior bonds, that their losses would have to be taken on board. This would result in extensive rapid deleveraging of the European financial system. This deleveraging, all agree, will have to take place.

It is surely in everybody’s interests that when it takes place, it takes place in an orderly fashion. And this is where the ECB has to come in. Its role is to act as lender of last resort. It is not to provide unlimited lines of credit to bankrupt private banks. The ultimate lender of last resort function is to provide sufficient liquidity to the system, through a variety of means including printing money, to act as a cushion.

There is an institutional, as well as governance, reluctance to countenance inflation in the ECB. That is admirable, but too rigid a policy is as calamitous as too flexible.

We have political power and we should use it. Even if the Government is forced to consider a unilateral decision; and I would favour that if we begin movement towards that using the powers of the Minister for Finance, the ECB will not cut off emergency liquidity. To do so would expose it as a neocolonial power.

I do not believe that it is such. Irish banks borrowed foolishly from European institutions. European institutions lent bullishly to Irish banks. The solution to date has been for the Irish taxpayer take on all of the adjustment. Time to call a halt.