Business Irish

Saturday 16 November 2019

ECB must share some of blame in Irish debt crisis

Three considerations are paramount in Ireland's struggle to deal with its debt crisis.

First, the causes of the crisis include the nefarious activities of a few individuals but are mainly comprised of mistakes by honest people who were lulled into complacency by an incomplete understanding of the new European monetary system. These honest people include many that still work for European institutions.

Second, the crisis was not expected to take the form that it did and European institutions were not -- and are still not -- equipped to deal with it. As a result, mistakes were made and are still being made.

Third, the Irish programme will have to be revised because it cannot be implemented as planned and the debt level is unsustainable.

In preparing for further negotiations, Ireland should use the time to examine and highlight: the extent to which it suffered from systemic defects in the eurozone; the way in which it was used to plug a hole in the European banking system that was not entirely of its own making; and how a more permanent and sustainable solution might be put in place to the benefit of all.

Of course, it is very necessary to examine mistakes that were made at home, to improve our own institutions and to punish law breakers. But three reports have now been completed and the situation is relatively clear. What is not so clear is why Ireland has been left with so much of the burden of the euro crisis on its balance sheet. This should be the main focus of any inquiry and it should be less about finger pointing and more about encouraging all of the main players -- at home and abroad -- to put their hands up and admit to mistakes made in good faith. Some may be ready to do so.

The Nyberg Report highlighted the role of a "herd mentality" but this raises as many questions as it answers. People move in herds in most economies because they react to the same market prices and incentives. The interesting question is what incentives made this particular herd stampede over a cliff. And part of the answer must lie with continual cheap funding from cross-border financial markets in the new eurozone. As pointed out in the Honohan and Watson-Regling Reports, people honestly thought that we had achieved a new level of wealth.

The extent to which fiscal and regulatory policies in Ireland could have contained the resulting boom can be debated and serious mistakes were made. But capital transfers to small economies were also far larger than anticipated and the de Larosière Report notes that the ECB should have been concerned about such localised credit booms when making monetary policy instead of focussing entirely on average inflation across the eurozone. Macro-prudential supervision will be enhanced in future but Ireland and other peripheral countries have suffered badly in the meantime.

And when the crisis broke, European institutions sometimes panicked in the absence of agreed procedures. The response to any banking crisis should be quantum, quick and quiet. But the Irish authorities did not fully realise the magnitude of the problem confronting them; any proposed solutions were slowly prepared and slowly approved in Brussels (as mentioned by Brian Lenihan recently); and ECB board members expressed loud frustration with having to deal with attendant liquidity problems.

This last element triggered a bank run.

The ECB's actions prompted a lot of commentary last week but it is fairly clear what happened. During last summer, the ECB had about €90bn in loans outstanding to Irish banks and this frustrated efforts to tighten monetary conditions, especially in light of a new ECB mandate to buy bonds of distressed countries. Deposits at domestic banks were slowly declining but deposits in offshore Irish banks were actually increasing.

But a sudden run on deposits began in September and €135bn was gone by November. Lorenzo Bini Smaghi of the ECB claims that this was caused by delays in dealing with domestic banks and by eroding confidence in the government guarantee. But these elements affect domestic banks only and the bank run affected domestic and offshore banks.

Offshore banks are not dependent on the Government for support. Both domestic and offshore banks depend on the ECB, however, and the bank run points to a common cause -- the threatened removal of ECB support.

Then, the ECB had to very significantly increase its support to Irish banks as a result of a run that it itself precipitated. An IMF programme was suddenly inevitable. It would probably have been necessary anyway, once the size of the bank problem became clear, but it could have been arranged quietly and without such a loss in deposits.

Moreover, it should have included a credible ECB commitment to the medium-term stability of the banks. We still do not have such a commitment and our banks continue to shed deposits.

In addition, Ireland was famously not allowed to impose a haircut on most bondholders and a great many of these have since been paid off with money from the ECB. The ECB has acted as lender of last resort, on behalf of the entire eurozone banking system, but Ireland is liable for all the sums that have been expended in this effort.

Most leading economists and commentators view this situation as untenable and unfair. Klaus Regling has admitted to failures by the EU. Axel Weber, who was the leading candidate to become the new head of the ECB, will resign because his advice was so different from other ECB governors. His objections included the pressure on Ireland to repay bondholders and he advocates a longer repayment period. It would be interesting to hear what all of these people could contribute to an inquiry and their evidence would surely bolster Michael Noonan's ongoing diplomatic offensive to secure more favourable terms.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and acts as an adviser to various governments

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