Smothered by our own blanket guarantee
Europe needs to learn from its bad choices and transform itself into a true monetary union
Given the profound alteration in Ireland's relationship with Europe since the last European elections in 1979, it is unfortunate that media coverage of the poll due on May 23 has consisted largely of parochial speculation about who will win in each constituency, a matter of no importance to anyone other than the candidates and their supporters.
There has been no discussion of party positions on European issues, since there appear to be none. There is no greater European issue than the failure of the common currency experiment and the continuing unwillingness to take the measures necessary to avoid a repetition. Not one Irish party has offered a vision of what a future European monetary union should look like, campaigning instead on complaints about austerity and unsupported promises of better jobs, decent wages and free water.
There are serious issues aplenty. In his recent book*, Philippe Legrain argues that the handling of the eurozone crisis by the EU Commission, and particularly by the European Central Bank, has been inept, deeply politicised and damaging to the broader European project. He is no eurosceptic; indeed his strictures are the more compelling because his concerns are those of a supporter of European integration. Legrain is particularly scathing about the actions of the European Central Bank under the presidency of Jean-Claude Trichet, including its dealings with Ireland.
The worldwide banking crisis became evident to even the less alert policymakers by the summer of 2007. The first European bank to go under was the German lender IKB, bailed out in July of that year. The source of its collapse was investment in US subprime mortgage securities peddled by Wall Street banks. There were numerous other banking tremors during 2007 including several in the US and Northern Rock in Britain. The crisis erupted the following year, culminating in the Bear Stearns collapse and rescue in March and the Lehmans' bankruptcy in September, followed promptly by the unravelling of the Irish banking system in the following months.
The textbook response to a systemic banking crisis is easily written: individual banks can be allowed to go under, particularly ones deemed to pose little threat to the broader financial system, but governments are understandably loath to let the broader banking system crash and invariably resort to ad hoc, often panicky, measures resulting in large taxpayer bailouts of bank creditors. These responses were universal in 2008 and 2009, the slow-motion panic in Ireland being merely the most egregious example.
Until such time as interconnected mega-banks are brought down to manageable size, small enough to fail at the expense of shareholders and creditors, governments will remain tempted to bail them out at taxpayers' expense, even at the risk of bankrupting national treasuries and imposing losses on those who prudently lent to solvent governments rather than to dodgy banks. Banks have not been required to raise extra capital in adequate amounts and many continue to pay dividends and extravagant bonuses, instead of using their operating profits to augment their thin capital buffers. As a result, they are reluctant to lend – and large areas of the eurozone continue to experience credit famine.
The result has been the longest and deepest economic downturn since the early years of the Second World War, instigated by an explosion in bank balance sheets devoted to poor lending and financed through excess debt with too little loss-absorbing capital. All of this was overseen by complacent central banks and regulators.
Only in the United States have measures been taken designed to ameliorate a repetition. In the eurozone, a policy of doing too little, too late remains stubbornly in place, currently enjoying a degree of apparent success through the untested expectation that the ECB will act as lender of last resort to the next round of bank busts. This expectation also explains the ability of over-extended European sovereigns to borrow at historically low interest rates in bond markets.
Legrain and numerous other writers have outlined a programme of reform in European banking which would offer better assurance that a repetition would be avoided. The mega-banks, some of which have balance sheets exceeding the national income of their home countries, are now 'too big to save' if there is another crisis. Too big to save means too big, and they should be broken up. There should be far higher capital standards – all banks should have shareholder risk capital on hand adequate to handle the inevitable loan losses which will arise from time to time. Those who finance them through the medium of bank bonds should also stand to lose if things go wrong. The 100 per cent bailout of bank bondholders and wholesale depositors who backed the wrong horse has been perhaps the single most damaging policy mistake made by European policymakers throughout the crisis, resulting in an expectation that the exercise will be repeated and resulting in a huge hidden interest-cost subsidy to large European banks.
Misdiagnosis leads to quack cures and the initial European response, which persisted from the onset of the crisis into 2012, was that the eurozone's problems derived from excessive budget deficits run by the countries experiencing the greatest liquidity strains. This line was peddled most vociferously by the European Central Bank whose line was followed slavishly by the EU Commission. With the solitary exception of Greece, the eurozone crisis was a banking bubble, not an orgy of fiscal excess. From a long list, Legrain picks the botched bailout of Greece in May 2010 as the original sin of the euro debacle. European politicians led by German chancellor Angela Merkel insisted that Greece, which was heavily indebted to French and German banks, was solvent and worthy of official credit when just about nobody else shared that view.
In due course, Greece defaulted on unsustainable private bondholder debts to the tune of €100bn, the largest sovereign default in history. The French and German banks emerged largely unscathed, protected from the losses their carelessness had earned. At the time of the first Greek bailout, IMF officials favoured a sizeable creditor haircut but were overruled by the politicians. When sanity finally prevailed and creditor losses were imposed, the default was inadequate – and Greece remains borderline insolvent to this day.
In Ireland, the panic decision to underwrite virtually all of the liabilities of the domestic banking system similarly protected capital providers to mismanaged banks from market discipline. By the time the balloon went up, Irish bank shares had been tanking for 18 months.
The blanket guarantee decision, which eventually cost enough to push the Irish State into insolvency and the tender mercies of the troika, remarkably still finds its defenders. In fairness to the European institutions, this initial decision appears to have been an Irish solo run but Legrain is clear-eyed about what the ECB did two years later. He writes: "Eurozone policymakers, notably ECB President Trichet, outrageously blackmailed the Irish government into making good on its guarantee by threatening to cut off liquidity to the Irish banking system – in effect threatening to force it out of the euro." He goes on: "This was a flagrant abuse of power by an unelected central banker whose primary duty ought to have been to the citizens of countries that use the euro – not least Irish ones."
My guess is that a majority on the ECB governing council approved this decision and that it was not taken by M Trichet on his own initiative. Since the ECB, unusually among central banks, does not publish minutes of its meetings, no paper trail is available. The same performance was repeated in April 2011, when ECB threats were again used against the incoming Fine Gael/Labour Government on the same issue.
Legrain goes on to outline the reforms which would turn Europe's dysfunctional and mismanaged common currency area into a proper monetary union, steps which have to date been taken only in part – to wit, the parts which least disturb the survival of the largely unreformed French and German banking systems.
This book, unfortunately lacking an index, is a spirited and readable account of the biggest policy failure to have afflicted the European project since its inception almost 60 years ago.
*Philippe Legrain, 'European Spring: Why Our Economics and Politics are in a Mess', Amazon, £12.99