Sunday 25 August 2019

Let's prepare for the long stay at rock bottom

As contagion spreads from periphery to core, a way out of this mess looks close to impossible writes Colm McCarthy

THE endgame for the eurozone is approaching. Italy and Spain are avoiding bond market expulsion only because the European Central Bank keeps the lid on the interest rates they face through purchasing bonds in the market. But the same ECB is unhappy with this policy, regards it as temporary and misses no opportunity to remind the market of its lack of commitment. If you are the little Dutch boy with his finger in the dyke, best not to keep shouting: "My finger hurts! I'm a coward!"

Bond investors have shouldered enormous losses, particularly those credulous enough to believe in the pseudo-solutions from innumerable European summits. They are thoroughly spooked by talk of a smaller eurozone, threatening Greek-style losses for holders of bonds issued by countries next on the list. The result has been a sell-off that spread last week from Spain and Italy to 'core' eurozone countries including Austria and France.

Non-European investors are beginning to avoid eurozone bonds altogether, even German ones. Dull, boring bond fund managers with a taste for the quiet life and AAA-rated, low-yielding, European sovereign bonds feel they have been lied to. There will be consequences for decades to come. Western European governments are now seen as dodgy credits, for the first time in 60 years.

None of this was inevitable. Financial panics can most readily be controlled through early and decisive interventions. The longer the authorities dawdle, the greater the ultimate economic cost. Delay has been compounded with policy errors, of which open discussion of heavily indebted countries leaving the euro is merely the most recent. If Greece, why not Portugal?

Policy-makers have contributed hugely to the bond market sell-off and are encouraging a deposit drain from banks in southern Europe. The continued insistence that fiscal reforms in the more indebted countries are all that is needed to stem the crisis is the most damaging error of all. Bond investors are wounded but not stupid. They know perfectly well that fiscal reforms will prevent the next crisis but cannot, on their own, prevent the immediate panic from running out of control.

It is the preferred policy position in both the ECB and the German government to do enough to delay the next worsening of the situation, while denying that subsequent action will even be contemplated. We started with 'no bailouts', followed by 'no defaults', followed by 'no eurozone exits'. The policy reversals have destroyed the European sovereign bond market, a piece of policy vandalism that will cast a long shadow.

The Irish Government's communications strategy in dealing with our European partners poses a dilemma. It is important to take commitments seriously and to be seen to do so. But where this veers over into unqualified optimism about the likely outcome of sticking to the existing programme, Ireland's case for a better deal is undermined. After all, if things are going so well, Ireland is not the problem. Unqualified expressions of faith in re-entry to the bond market "late next year" create the impression that Ireland will be off the casualty list pretty soon, implying that the terms of the existing deal are good enough to ensure this happy outcome. Why offer burden-sharing on bank debt to a country that believes it can re-enter the market unaided?

The professions of faith in unconditional bond market re-entry are doubly damaging if they are not credible. When Ireland emerges from reliance on official lenders, and with the budget deficit down to zero, the sovereign debt is projected to have reached about €180bn.

The State will need to sell between €15bn and €20bn of bonds per annum on average just to re-finance maturing debt. Whether that proves to be possible nobody can tell. But countries in a better position are already struggling in the demoralised European bond market, where interest spreads charged to several AAA-rated sovereign borrowers are higher now than they were before the euro was launched.

The phrase 're-entering the bond market' is in any event imprecise. Until such time as the countries relying on official lenders can borrow large amounts at long maturities and low interest rates, they have not 're-entered' the market in any meaningful way. Selling small quantities of short-term paper at unaffordable rates is entirely pointless.

For Ireland's prospective debt burden to be manageable, several things need to happen. The budget deficit needs to be reduced quickly and ideally to zero. The economy needs to start growing again at a decent rate. The European sovereign debt market, victim of devastating collateral damage from the policy failures of the last few years, needs to be reconstructed. And there had better be no more nasty surprises from the banking system.

It is plausible that things could work out: there is always a combination of assumptions that will make the sums add up no matter how high the debt level. But no government can control all the moving parts, and it is time to acknowledge that Ireland may never graduate from reliance on official lenders through its own efforts.

This is not to argue that these efforts should be abandoned, since there is no alternative to getting the budget deficit under control. But it needs to be made clear to our European partners that the Irish debt burden has been pushed to a level, because of the disproportionate Irish contribution to rescuing bank creditors, which could make the task impossible.

Economist Alan Ahearne from Galway University addressed a conference of corporate treasurers in Dublin last Wednesday. He pointed out that the addition to Ireland's debt arising from bank rescue costs amounts to 40 per cent of GDP, the highest figure he could find for any bank rescue there has ever been, anywhere in the world.

The folks who got rescued were the creditors of the bust banks, including those European investors foolish enough to buy bank bonds without any legitimate expectation of recourse to the Exchequer. Without these horrendous costs, the Irish debt-to-GDP ratio would today be lower than the figure for Germany.

The Government realises that these costs, partly self-imposed through the rash bank guarantee but also sustained at the unexplained insistence of the European Central Bank, are excessive and unreasonable.

Finance Minister Michael Noonan has indicated that he expects some sharing of this burden from our European partners, whose financial institutions are the principal beneficiaries of the crippling burden imposed on Irish taxpayers. Ireland's case is weakened every time some minister or public official asserts that "the programme is working" and that Ireland will re-enter the bond market soon, festooned with rosettes awarded by official lenders.

Given the damage inflicted on the sovereign bond market by European policies, the rosettes are worth nothing at all when push comes to shove, as eventually it must. The 40 per cent of GDP embedded in Ireland's national debt as the cost of bailing out bank creditors (not banks, not bankers, not bank shareholders, not developers, but first-in-line bank creditors elsewhere in Europe) is not just unfair and unreasonable, it makes graduation unlikely for the best student in the class.

No financial panic has ever been ended by a central bank which stands aside, blaming the markets. The euro project will go down in flames unless the ECB acts to ensure financial stability. German Chancellor Angela Merkel continues to insist that the ECB, the only institution with the unambiguous capacity to end the crisis, should decline to do so and she continues to enjoy support from prominent economists in Germany. The online edition of Der Spiegel reported during the week: "Wolfgang Franz, head of the influential German Council of Economic Experts -- which advises the government on economic issues -- expressed vehement opposition to unlimited ECB bond purchases.

"'History has shown us, and not just in Germany, that the monetisation of state debt is a deadly sin for central banks,' Franz told the Frankfurter Allgemeine Zeitung in an interview published on Thursday.

"'Doing so not only results in a loss of independence, but it also raises the risk of inflation. Finally, it also represents the undemocratic collectiv-isation of debt under the auspices of the ECB."'

Professor Franz, and numerous other opinion-leaders in Germany, could do with a tutorial on the "collectivisation of debt under the auspices of the ECB". It is the Irish Government's job to communicate effectively that debt has been collectivised on an industrial scale, and at the insistence of the ECB, in Ireland. The Government has failed dismally to get this message across where it counts, in Germany.

Sunday Independent

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