ECB is leading Ireland and the eurozone to disaster
Moralising lectures about fiscal policy and austerity will not resolve the European banking crisis, writes Colm McCarthy
Published 01/05/2011 | 05:00
The EU Council, the Commission and the European Central Bank have made substantial progress in preparing new oversight and supervisory arrangements, a permanent rescue fund and arrangements for better scrutiny of public finances. All of this is designed to prevent Europe's next financial crisis. However, they have been doing a less impressive job in handling the current crisis, which is now in its third year.
Yields on Greek government bonds have reached stratospheric levels, implying that the markets regard a Greek default as a virtual certainty.
Both Irish and Portuguese yields suggest that the markets also see very high default probabilities in these countries.
Greece and Ireland have been the beneficiaries, if that is the correct term, of rescue packages designed to ameliorate their financial crises. Portugal is next in line.
But all three countries now face the prospect of sovereign default. There has not been a sovereign default in Europe for almost 60 years.
In a BBC radio interview with Dan O'Brien of The Irish Times on Sunday last, former Finance Minister Brian Lenihan revealed that the European Central Bank had hastened Ireland's application in November 2010 for financial support from the IMF and the EU.
At that time, there had been suggestions over several weeks that the ECB would withdraw or reduce liquidity provision to the Irish banking system, thus forcing the Irish Government's hand.
The ECB's actions have been described as 'bouncing' Ireland into a deal with official lenders whose terms are regarded by many economic commentators, in Europe as well as in Ireland, as both unfair and unfavourable.
The deal has failed to resolve the banking crisis and has continued the policy of favouring bond investors in failed banks. It has also created a widespread perception that the ECB is not greatly concerned about the prospect of sovereign default in eurozone member states including Greece, Ireland and Portugal, all of whom are currently excluded from sovereign debt markets and with no visible re-entry strategy.
If you believe that by November Ireland was already shut out from the markets and unlikely to avoid resort to official lenders, this could all be dismissed as a storm in a teacup. A deal with the IMF/EU was coming anyway and no damage was done by precipitating the inevitable.
On this view, the Government here was in denial about the scale of the liquidity crisis and a few sharp prods helped to encourage a more realistic course.
But hasty entry into an unfavourable and unimplementable deal is a different matter and the behaviour of the ECB has created resentment in Ireland.
It appears that policy is being dictated to an elected government by a remote and unaccountable financial authority and that the policy is not self-evidently a good one.
If Brian Lenihan is to be believed -- and what he has been saying is certainly consistent with information already in the public domain -- the EU Commission also took a different line from the ECB in the weeks leading up to Ireland's November deal.
The ECB policy line for Ireland -- at least the public version -- can be summarised as follows. There must be generous treatment of bank bondholders, because the Irish failed to supervise the banks properly, and guaranteed (most of) their liabilities. Failure to pay bondholders cannot be contemplated, because of either moral obligation or contagion risks.
It is being assumed that the financial situation can be resolved solely through a further tightening of budgetary policy. This in turn assumes that there is no risk of sovereign default and that all debts can be paid, which implies that the markets have got it wrong.
Alternatively, if the markets are right and there is a sovereign default, then that's just too bad.
This policy is also being pursued for Greece and Portugal, at least until it becomes untenable, which could happen pretty soon in the case of Greece.
The EU's political leadership has meanwhile contributed a proposal to include punitive collective-action clauses (against the lenders) in government bonds issued from 2013 onwards, with the possibility of haircuts also for pre-existing government debt of distressed eurozone members.
The verdict of the sovereign credit markets on all of this is clear and unsurprising. They will not lend a cent to Greece, Ireland or Portugal for the foreseeable future and do not believe that fiscal tightening alone will do the trick. As a consequence, there is no visible exit strategy for these countries.
The absence of a visible exit strategy places their governments in an impossible position. They cannot fashion a credible political message for their electorates, offering a credible probability of success in exchange for more fiscal pain.
It is not politically viable to tell people that further large tax increases are coming, along with more big cuts in expenditure and no bank credit, with no prospect of economic recovery and no end in sight. The 'rescue' package cannot be sold as a kind of economic black hole from which there is no escape.
The additional perception that this formula is being imposed by a central bank that most citizens had never heard of prior to the crisis does not help public acceptability, nor does the incessant sermonising from EU and ECB officials.
The likely result is political instability in these countries, with increasing support for anti-European political parties.
The further fiscal tightening desired by the ECB is substantial in all three countries, as it is in Spain if that country is to avoid a one-way ticket into the aforementioned black hole.
In Ireland, taxes have already been increased dramatically, social welfare payments have been cut, capital projects have been cancelled or deferred and public service pay has been cut twice.
Further measures are both necessary and desirable but the politics needs a visible exit strategy, which means a restored ability to access sovereign credit markets on affordable terms.
Any rescue package which does not deliver this prospect runs a high risk of failure and the verdict of the markets looks to be decisive.
The commitment to further fiscal consolidation is undermined once the public and the politicians conclude that existing debts can never be refinanced in the markets.
The EU Commission and the ECB seem to believe that further budgetary corrections, as envisaged in the Memorandum of Understanding and accepted by the Irish Government, will see Ireland re-enter the bond market successfully in the second half of 2012.
Virtually all bank bondholders will be paid back along the way and the banks will have been recapitalised and will be able to fund themselves.
If the markets, which Ireland must re-enter within 18 months, believed all of this, then Irish 10-year bonds would not be offering yields of 10.6 per cent, as they were on Friday.
If the markets do not believe that the exit strategy (a successful return to the markets before the end of 2012) is credible, then the game is already up.
What, precisely, do the EU and ECB expect to happen that will change this scenario?
In the Irish case (but not the Greek), outstanding debt includes enormous obligations to repay bank bondholders. These were imprudently undertaken by the Government in the belief that the banking problems were much smaller than they actually are.
The result is that Irish taxpayers have already transferred substantial sums to investors who made losing bets on Irish bank bonds and they are expected to make further transfers in the future.
Some of the banks whose bondholders have already been paid off have lost eight and 10 times their equity capital. The perception that the costs of the European banking crisis are being borne disproportionately by Ireland is corrosive of public support for desirable policy reform.
Economist Paul de Grauwe has argued that the very design of the eurozone created high risks of sovereign default for non-core EU members who were rash enough to join the single currency.
It is patently clear that these risks were under-appreciated in Ireland but it is dispiriting to have to listen to lectures from ECB officials who appear to regard the European banking crisis as essentially a morality play about fiscal policy.
The policy reforms designed to prevent another crisis are worthy and may work. But unless the European banking crisis is acknowledged and dealt with soon, we are witnessing a slow-motion train-wreck that will end badly for Ireland, for several other eurozone members and ultimately for the entire European project.
Colm McCarthy lectures in economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua. He is also the author of the report into the semi-state sector from the Review Group on State Assets and Liabilities.