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Turning down the lender of last resort not an option

The 31st Dail is set to assemble on March 9 and the new government will be faced immediately with a critical European summit at the end of March. This summit is intended to agree a new and hopefully more coherent response to the European banking and sovereign debt crises, including decisions about enlarging the bailout fund and tighter fiscal rules for eurozone member states.

From an Irish perspective, what matters most is whether this summit decides to address the bank insolvency problem on a pan-European basis or continues to expect individual members to recompense bank bondholders even where this runs the risk of sovereign default.

Detailed proposals are emerging for a new regime post-2013, intended to equip Europe to deal with the next crisis. Meanwhile, the current crisis lumbers on unaddressed. After a week of general election campaigning, the critical issues to be decided in Brussels at the end of March have received very little air-time. Indeed some of the proposals floating around are escapist and divorced from the practical realities.

Left-wing parties and candidates, as well as some independents on the political right, are proposing the unilateral abrogation of the deal with the IMF and the European Union. The undiluted version is that these organisations should be invited to 'clear off' and take their money and their austerity plan with them. The only snag with this otherwise attractive wheeze is that these folks are furnishing Ireland with €67.5bn in loans over the next three years in circumstances where no other lenders are available. The amount offered will be just enough to finance the huge budget deficits planned under the four-year plan, the recapitalisation of our bust banks and the refinancing of various debts as they fall due. It will be a tight squeeze even with €67.5bn.

Should they be induced to clear off, taking their money with them, an alternative source of €67.5bn would have to be found immediately, since debt refinancing for both banks and government is a continuing drain. The banks, according to figures released last week, suffered another enormous haemorrhage of liquidity during December. The reason the Government resorted to the official lenders is that it and the banks were unable to finance themselves anywhere else. It follows that those who would like the €67.5bn to clear off must contemplate failure to finance the planned budget deficits. The banks would close pretty quickly without the IMF/EU support. Such wholesale deposits would evaporate, emergency liquidity from the ECB would be withdrawn and retail depositors could not be repaid. Government cheques would bounce. A state unable to finance either itself or its banks cannot unilaterally decline whatever is on offer from the lender of last resort, in this case the IMF/EU.

Remaining NPRF funds and the cash reserve have been spent several times over through the campaign to date. Unfortunately the money in both of these funds has been borrowed. One election candidate described the pension reserve as a 'sovereign wealth fund' on TV during the week. Sovereign wealth funds are operated by governments which have large net external assets, including those lucky enough to have accumulated foreign earnings from oil and gas.

The Irish Government jumped the gun by establishing a fund while it still had large debts, and the debts easily exceeded, even at the top of the bubble, the assets in the fund. Thus the NPRF is, and always was, a hedge fund, short bonds and long equities, and not a sovereign wealth fund. Think of it this way. You have no debts, no assets and no pension. You borrow €1m from the bank and buy €1m worth of shares. Do you now have a pension fund? Common sense says you do not; you have a long/short hedge fund, and a pretty exposed one. If equity shares outperform the cost of debt, you might make some money, if not, you could lose.

Certainly you would be foolish to proceed as if you owned €1m and started thinking about things to spend it on. You could confidently run for the Dail perhaps, but it would be best to leave the family finances to someone else.

Election candidates who refer continually to the dwindling NPRF funds, or the dwindling cash reserve, as somehow available to avoid the inevitable consequences of doing without €67.5bn from the IMF/EU, are throwing sand in the eyes of the public. The cash reserve represents advance borrowing by the Government which has been deposited with the Central Bank, at a substantial interest cost. Some people like to keep some money in the bank even though they owe the bank a larger sum at a higher interest rate. If you do this and feel a little silly about it, relax. The Government does the same. This cash reserve, and what is left in the NPRF, is spoken for. Of the €15bn left in the NPRF, €10bn has been earmarked for bank recapitalisation. If the banks are not recapitalised, they will have to close. Either their licenses will have to be withdrawn due to failure to meet capital adequacy ratios laid down by the Central Bank and included in the deal with the IMF/EU, or further wholesale deposits will walk. The surviving Irish banks need to be recapitalised, it should have been done long ago, and there is no one to do it but the Government.

The cash reserve is spoken for, too; it must be run down to repay short-term debt as it falls due. Both of these funds have been factored in to the cash-flow plans in the deal with IMF/EU. They are dwarfed by the IMF/EU funds being advanced to Ireland and are not available in any event to defer dealing with reality.

The minimum wage in the UK was increased last October to the level of £5.93 per hour for those over 21. This equals just under €7 per hour at current exchange rates. From this month, the adult rate in Ireland will be €7.65 per hour, 10 per cent ahead of the UK rate.

Both Fine Gael and Labour, the likely coalition partners, have committed to restoring the Irish rate to its previous level of €8.65 per hour, to a premium of 24 per cent over the new UK rate. Rates of pay throughout the public and private economy have drifted well above comparable UK rates over the last decade. Taoiseach Brian Cowen is paid more than British Prime Minister David Cameron, while judges, hospital consultants, university staff, police officers, nurses, teachers all enjoy pay and conditions ahead of what is available in comparable UK employments.

What basis is there for sustaining pay levels in Ireland 20 per cent and 30 per cent ahead of what is on offer in the UK, with which we share a common labour market? It would be reasonable for political candidates to promise that low-paid workers be spared from extra tax burdens. It is not reasonable to promise a recovery in employment while seeking to sustain payroll costs to Irish employers so far ahead of our nearest competitor.

There is plenty of political choice about the composition of future budgetary measures, but none about the course which should be followed. The 1980s recession in Ireland lifted when public finances were finally brought under control, and that was no coincidence. Had tougher measures been taken sooner, economic recovery would have commenced sooner, too.

The search for softer options is futile in a country swimming in debt, reliant on official lenders and planning to borrow another 10 per cent of GDP in the coming year alone. There is no policy available which does not involve a deflationary stance over the next few years.

The impression being created is that reducing the deficit is not something we would choose to do were it not for the hard taskmasters from Washington and Brussels. It never makes sense to borrow 10 per cent of GDP per annum, at steep interest rates, and then dither for years about the expenditure cuts and tax increases which are inevitable. The lesson of the 1980s is that spinning out the adjustment over a longer period buys you a longer recession and a higher ultimate debt burden.

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

Sunday Independent