Says Financial Times Deutschland commentator, Wolfgang Munchau, with whom I agree with in most issues. However, when it come to the well-being of Irish bondholders, I don’t have enough information to form an opinion. So, read this interesting post by Mr, Munchau and decide for yourself.
“For a risk-averse politician, dumping the cost on the taxpayer is easy. For the economy it is a nightmare. It is also politically dangerous in the long run, as the distributional unfairness will favor extremist political parties.”
No matter how much debt you might have, there always exists a projected income growth rate at which you can pretend to be solvent. The projected rate of growth is the issue on which I differ most with those who claim that Ireland is fundamentally solvent. They are moderately optimistic about future growth whereas I am not.
The Irish government last week recognized the scale of the country’s banking problem, and it deserves credit for that. The decision to recapitalize Anglo Irish Bank, the bank at the heart of Ireland’s property meltdown, will raise the country’s deficit to 32 per cent of gross domestic product this year.
I am not worried by that number or by the projection that the debt-to-GDP ratio is headed towards 100 per cent. What I am worried about is the combined effect of bad policies in Ireland and a deteriorating external environment on Ireland’s solvency.
First, Dublin is still not realistic about what constitutes a worst-case scenario. A fall in commercial property prices by 65 per cent with no subsequent increase this decade hardly qualifies. This is merely a description of a medium-sized bubble – not the real-estate madness we have actually witnessed. Should that not be the central scenario?
Second, and most important, the Irish government and several private sector economists are delusional about the effects of a financial crisis on growth. History tells us it takes a long time for economies to revert to normal after a big financial crisis. In the case of Ireland, where the crisis is one of the biggest ever recorded, a real worst-case scenario would include stagnation for up to a decade, mass emigration, further falls in house prices, a significant fall in tax revenues, more austerity in response, and the further banking problems that would result from such a toxic mix.
I am not predicting this scenario, but it is at least as plausible as Dublin’s naively optimistic V-shape-recovery assumptions.
Third, the monetary environment is going to be tough. The Irish government currently pays an interest rate on 10-year bonds of well over 6 per cent at a time when goods prices are stagnating and asset prices declining.
This implies real long-term interest rates approaching double-digits. A bail-out through the European Financial Stability Facility is not going to help. The EFSF will offer finance when others do not. It will be useful when markets seize up. But rates are hardly going to be more attractive than current market rates.
Short-term finance from the European Central Bank is still cheap, but I expect European short-term rates to go up soon. Last week, overnight euro zone interest rates had already more than doubled to 0.9 per cent.
It looks as though the ECB is preparing the ground for a shift in monetary policy, and we should factor this into our calculations. The euro’s exchange rate is an additional source of tightness. After a brief period of weakness earlier this year, the euro is back to a level that I would consider moderately overvalued.
So if you combine all these factors with an observed slowdown in the global economy, it is unreasonable to assume that Ireland will return to normal growth rates once the acute phase of the crisis is over. Even a decade of stagnation is hardly a worst-case scenario.
So what should Ireland do? Recognizing the scale of the problem was a good decision.
The fundamental problem with the Irish government’s approach was the decision to dump almost the entire adjustment burden on to the taxpayer, rather than to accept or negotiate a partial default.
I am aware that there are legal impediments to the participation of the bondholders in the bank rescue costs. You cannot simply apply a haircut on a bond unless the issuer has formally declared bankruptcy. Dublin is now preparing legislation that would allow it to apply a haircut to the subordinate debt.
First, coming two years after the beginning of the crisis, this is absurdly late.
More importantly, it is just peanut-sized symbolism, especially as no haircut will be applied to holders of senior debt. My concern is that Dublin is overburdening the taxpayer, and might worsen the downward spiral.
This is not just an Irish problem. European governments everywhere are scared of touching bondholders. I had been wondering about this default-phobia for some time.
The most plausible explanation I have heard is based on an asymmetry of risk. Haircuts are a legal minefield, and politicians find it more expedient to dump the problem on the taxpayer than to risk a hugely damaging defeat in court. Some politicians are inclined to always agree with the last person they have spoken to, and the power of the banking lobby is clearly a factor.
For a risk-averse politician, dumping the cost on the taxpayer is easy. For the economy it is a nightmare. It is also politically dangerous in the long run, as the distributional unfairness will favour extremist political parties.
The European political establishment recoils so much at the idea of default, it is willing to accept extreme hardship. Just look at Latvia. But Latvian brutalism is not going to be realistic for Ireland. Brian Lenihan, the Irish finance minister, might wish to ponder whether his monumentally unfair taxpayer bail-out is what will ultimately “bring down Ireland”.
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