What If Ireland Defaults? (29 page)

Few people thought that these lessons might apply to the Eurozone, but some have now argued for the introduction of a Eurozone SDRM to make debt restructuring more efficient and avoid the ‘gambles for redemption' that have pushed many countries to the limit.
²⁹
The Eurozone had been blind to the possibility of such problems and there was an implicit ban on default that saw most countries pay similar interest rates and, in some cases, accumulate too much debt. This was bad enough, but Germany and France then agreed to introduce debt restructuring as an option – to be known as ‘private sector involvement' – before later insisting that it would only apply to debt issued after 2013. The Eurozone got stuck in the horns of the debt dilemma – it first exacerbated the debt problem by scaring capital away and then ruled out the obvious solution: selective default.

And it was an open secret that the IMF was frustrated by a ban on sovereign default in the Eurozone that, eventually, wore very thin. Default is not the enemy, the IMF probably said, because it sometimes cannot be avoided. Disorderly default is the enemy and must always be avoided. And often, when you rule out the option of an orderly debt default, or delay it for too long, you can make a disorderly default inevitable.

Endnotes

¹
See

for a description of the work of the IMF.

²
Even countries that do not repay the IMF on time are denoted as being ‘in arrears' rather than ‘in default' because the IMF is always confident that it will be repaid some day, when the countries have sorted their problems out. At the time of writing, the Sudan, Somalia and Zimbabwe are ‘in arrears' to the IMF and have been so for many years. (See

).

³
John Maynard Keynes (1920),
The Economic Consequences of the Peace
, New York: Harcourt, Brace and Howe.

⁴
The London Conference on German External Debt of 1953 took into account the repayment capacity of Germany's economy and its debt was reduced to about one-third of its nominal value (Enrique Cosio-Pascal (2008) ‘The Emerging of a Multilateral Forum for Debt Restructuring: The Paris Club', UNCTAD discussion paper no. 192, available from:

, p. 5).

⁵
Even if the IMF is owed money, it is always regarded as a ‘preferential creditor' and will be the first to be repaid and will be repaid in full. This is because the IMF's resources belong to all countries and because the IMF is always the first to lend into a difficult situation. If Zimbabwe comes back into good standing with the world, for example, it will first have to repay the IMF what it owes – even if this involves getting a bridging loan from another country.

⁶

. Also,

.

⁷
Cosio-Pascal, ‘The Emerging of a Multilateral Forum for Debt Restructuring: The Paris Club'.

⁸

.

⁹
Other private sector creditor forums are established from time to time, including the Institute of International Finance that negotiated private sector involvement in the Greek debt restructuring of 2011.

¹⁰
Carmen M. Reinhart and Kenneth S. Rogoff (2008) ‘This Time is Different: A Panoramic View of Eight Centuries of Financial Crises', NBER working paper no. 13882, available from:

provide an extensive guide to debt defaults and restructurings. See, in particular, Tables 4 and 5.

¹¹
Federico Sturzenegger and Jeromin Zettelmeyer (2006)
Debt Defaults and Lessons from a Decade of Crises Cambridge
, MA and London: MIT Press, pp. 21–22.

¹²
Ibid
, pp. 22–23.

¹³

.

¹⁴
IMF (2001) ‘Involving the Private Sector in the Resolution of Financial Crises—Restructuring International Sovereign Bonds', available from:

, pp. 27–28.

¹⁵
IMF (2002a) ‘Sovereign Debt Restructurings and the Domestic Economy: Experience in Four Recent Cases', available from:
,
, pp. 32–33.

¹⁶
Ibid
, p. 3.

¹⁷
IMF (2002b) ‘The Design of the Sovereign Debt Restructuring Mechanism—Further Considerations', available from:

, p. 5.

¹⁸
Anne Krueger (2002) ‘Should Countries like Argentina Be Able to Declare Themselves Bankrupt? A Commentary',
El Pais
, 18 January, available from:

.

¹⁹
Ibid
. A ‘vulture fund' is one that buys up shaky, and cheap, bonds on the secondary markets and then tries to force the debtor to make a complete payout.

²⁰
IMF, ‘The Design of the Sovereign Debt Restructuring Mechanism—Further Considerations', p. 4.

²¹
Ibid
, p. 6.

²²
Kreuger, ‘Should Countries like Argentina Be Able to Declare Themselves Bankrupt? A Commentary'.

²³
IMF, ‘The Design of the Sovereign Debt Restructuring Mechanism—Further Considerations' for a full set of proposed procedures and principles.

²⁴
Ibid
, p. 73.

²⁵
See Brad Setser (2006) ‘The Political Economy of the SDRM',
Council on Foreign Relations
, pp. 1–2.

²⁶
John B. Taylor (2002) ‘Sovereign Debt Restructuring: A US Perspective', speech at the conference
Sovereign Debt Workouts: Hopes and Hazards
, Institute for International Economics, Washington, DC, 2 April 2002, available from:

.

²⁷
Nouriel Roubini and Brad Setser (2003) ‘Improving the Sovereign Debt Restructuring Process: Problems in Restructuring, Proposed Solutions, and a Roadmap for Reform', paper prepared for the conference
Improving the Sovereign Debt Restructuring Process
co-hosted by the Institute for International Economics and Institut Français des Relations Internationales, Paris, 9 March 2003, available from:

, pp. 25 and 28.

²⁸
Anna J. Schwartz (2003) ‘Do Sovereign Debtors Need a Bankruptcy Law?',
Cato Journal
, Vol. 23, No. 1, pp. 87–100, available from:

, p. 87.

²⁹
Beatrice Weder di Mauro and Jeromin Zettelmeyer (2010) ‘European Debt Restructuring Mechanism as a Tool for Crisis Prevention', 26 November 2010, available from:

.

15

A Politician's Perspective on Debt and Default

Peter Mathews

Peter (BComm, MBA, AITI, FCA) is a chartered accountant and banking and finance analyst. In 2011 he was elected TD (Member of Parliament) to Dáil Eireann, the lower house of the Irish Oireachtas.

The Keane Report on distressed mortgages was a missed opportunity to face up to reality. Households are drowning in debt that is crushing our economy. This harsh reality will not disappear by ignoring it or putting it on the long finger. It can only be resolved by writing down mortgage debt across the board. We need to have an honest discussion about the levels of debt in Ireland. The central question that needs to be answered is this: how much debt is too much for the country to handle?

Central bankers from across the world discussed the international debt crisis at a meeting in Wyoming in August 2011. A keynote paper presented by Bank of International Settlement economists to the conference analysed the impact of the combined debt levels of governments, households and businesses on economic growth across a number of countries. It concluded that government debt in excess of 100 per cent of national income damages growth, household debt in excess of 85 per cent of national income damages growth and business debt in excess of 90 per cent of national income damages growth.

These figures are striking because Ireland exceeds these levels for government, household and business debt. Government debt in Ireland stands at 137 per cent of national income, household debt is 147 per cent of national income and business debt is 210 per cent of national income. The combined total for these three debt elements is 494 per cent of national income.

The report continues by listing the combined debt – the sum of government, household and business debt – for eighteen developed countries. Ireland was not included on this list. However, the Department of Finance provided me with the Irish figures in a response to a parliamentary question. Combined debt levels in the Irish economy are almost twice those of the Greek economy. For every €1 billion of debt in the Greek economy, there is €1.8 billion in the Irish economy. If debt levels in Greece have reached the point that a sovereign default is imminent, what does this mean for Ireland and what should Ireland do about it?

It is even more disturbing to see that Ireland tops this league table ahead of Japan. Japan's combined debt levels have flattened its economy to the point that the period since 1990 is frequently referred to as ‘the lost decades'. It is crystal clear that the current Irish combined debt levels will suffocate any chance of a robust economic recovery. It is clear that we must reduce our overall debt burden.

The high private debt levels in Ireland are very noteworthy. They place a limit on the amount of austerity that is possible. It is often commented that Irish public sector wages and social welfare rates are far too generous. Between them, they account for two in every three Euro that the government spends. If we are to balance our budget through austerity alone, it is most likely that spending will have to be slashed in both of these areas. To analyse the impact this will have on the economy, take the example of a family comprising of a Garda and a teacher with two children who bought a modest house in recent years. They are receiving wages that, by international comparisons, are very high. They are receiving child benefit that, by internal comparisons, is remarkably generous. The austerity approach is to slash public sector wages and social welfare spending, perhaps down to the Western European average. Out of context, this seems entirely reasonable. Why should European taxpayers provide us with cheap loans to pay social welfare benefits and wages at levels that they cannot afford? However, the impact that this would have on the family in this example must be considered.

Their take-home pay will be drastically reduced along with the income they receive in child benefit. This is likely to mean that they will be unable to meet the repayments on their mortgage. Their disposable income will shrink towards zero. Any discretionary spending they did will end immediately. When you consider that there will be a similar effect in every similar household in the country it is clear to see the economic collapse that would occur. The amount of bad loans in the banks would explode. The amount of spending in the economy would dry up to a trickle, forcing businesses to lay off staff or go out of existence. All of these consequences would cost the government more money. More mortgages in default will force the government to pump more money into the banks. More unemployment means that tax revenue will fall and social welfare expenditure will increase. This makes it impossible to balance the budget. This is the dilemma that Ireland is in. Without robust economic growth, we are stuck between a rock and a hard place. We need to balance our budget, but implementing austerity measures in the absence of robust economic growth is damaging our economy to the extent that it is impossible to balance the budget. Grafton Street is bustling every weekend. If we were to balance the budget in a one-off swoop, tax increases would be so penal and reductions in social welfare payments and public sector pay would be so crippling that few would have the cash to shop. Grafton Street would be empty of people and full of boarded-up shops. Its atmosphere would resemble that of a ghost estate rather than a bustling city street.

The high private debt levels in Ireland place a definite limit on the amount of austerity that can be introduced. Once this point is passed, further austerity will simply cause more mortgages to become bad loans. This will force the government to provide further recapitalisation to the banks. This will put the country into a hopeless downward spiral. What proponents of endless austerity do not understand is that you cannot get blood out of a stone. There is a limit to the amount of austerity that an economy can take. We need to ask ourselves whether we have passed this point. Ireland's budget deficit peaked at €23 billion in 2009. €21 billion of austerity measures have already been implemented. Despite this, our budget deficit is stuck at €15 billion, excluding the cost of the bank bailout. Clearly, austerity isn't working.

The reason that austerity is taking place over a number of years is so that economic growth can return and lessen the impact of austerity. However, the domestic economy seems dead on its feet and will remain so until austerity ends. Exports are remarkably strong but our export partners are now facing very problematic economic problems of their own. If their demand for our goods dries up we are unlikely to experience any significant economic growth. Without robust economic growth austerity simply will not work. Austerity will not work unless it is accompanied by a huge stimulus to the economy to keep money circulating around the economy. The most obvious source for this stimulus was the National Pension Reserve Fund. However, this has now been almost entirely emptied into dead banks. The only possible way to have a stimulus in the Irish economy is to write down bank debts to the European Central Bank (ECB) and, in turn, pass these write-downs onto Irish households and businesses.

It is acknowledged that loan losses in the banks are in the order of €65 billion. Over a period of eighteen months up to March 2011, while the scale of losses had been denied by the previous government, the banks found themselves unable to repay in full the claims of senior bondholders which were becoming due for repayment. Were it not for ECB funding, the bondholders would have been largely wiped out. The ECB took a decision to protect the bondholders and loaned to the banks the €70 billion needed to redeem in full the bondholders. As the scale of losses became clear, deposits started to fly out of the banks. The combination of replacing deposits and repaying bondholders left the banks owing the ECB and the Central Bank of Ireland in excess of €140 billion. The scale of loan losses blew a hole in the banks' balance sheets to such an extent that the banks could not repay their bondholders. Without ECB funding, the bondholders would have been largely wiped out. The ECB took the decision to protect the bondholders. Clearly, this was inappropriate and therefore we can say with justification that half the money owed by the banks to the ECB and the Central Bank of Ireland is odious debt. Through a political chain of events it has ended up on the backs of Irish citizens and this is patently unfair. In a nutshell, the senior bondholders have received a get out of jail card and the Irish citizen has been locked into an austerity jail. The ECB's treatment of Ireland amounts to making Ireland the sacrificial lamb for European financial stability.

Many commentators believe that the government's hands are tied and that we must accept diktats from Frankfurt because we have no room for manoeuvre and no cards to play at the negotiation table. Nothing could be further from the truth. The ECB has lent almost €100 billion to the Irish banking system. They did this to ensure that European banks could be repaid the full value of their bonds with interest. The collateral on this emergency funding can be removed. The Credit Institutions (Stabilisation) Act 2010 allows the Minister for Finance to force burden sharing onto the ECB. The then President of the ECB, Jean Claude Trichet, was so disturbed by this Act that he signed off on a seven-page opinion criticising the legislation.

By moving loans to a newly established bank, the Minister for Finance can remove the ECB's collateral on emergency funding to Irish banks. This puts the Irish government back in the driving seat. It allows for burden sharing to be forced on the ECB and remaining senior bondholders, resulting in a realistic and workable resolution to Ireland's banking crisis. In turn, it allows for write-downs on unsustainable mortgages, at no further expense to taxpayers, which would provide a vital boost to an economy suffering from years of austerity.

There is precedent for this. It is precisely the approach that Iceland took in dealing with its banking crisis, with the blessing of the IMF. Iceland moved banking loans to entirely new banks and wrote down the principal on mortgages by 30 per cent. The bondholders were forced to pay for these write-downs. Moving Irish loans to new banks would effectively remove the ECB's collateral and allow the Minister for Finance to force burden sharing on the ECB.

The ECB is reported to have forced the previous Irish government into a bailout by threatening to cut off funding to the Irish banks. No other central bank in the world behaves like this. It is inconceivable that the Bank of England could bully the British government like this or that the Federal Reserve could treat the US government like this. The ECB has turned into an over-domineering central bank and need to be reined in. We should remind them that with a stroke of the Minister for Finance's pen, their collateral on the funding to Irish banks collapses and their power over our country disappears.

Yields on Irish government bonds fell by almost 40 per cent in the aftermath of Europe reversing its intention to charge Ireland the original draconian interest rate on its bailout loans. Forcing burden sharing on the ECB and passing this on to mortgage holders through loan write-downs would have a far greater positive impact on Ireland's solvency. If yields were to fall substantially again, Ireland would be very close to leaving the EU/IMF/ECB bailout and re-entering the markets. It's time to challenge the ECB's ‘no bondholder left behind' dogma. We must assert ourselves to defend our economy and protect our people.

Minister Noonan is quite right to continue raising bondholder burden sharing with the ECB because it is no longer just an economic problem. It's a political problem. The banking losses were incurred and should have been recognised long ago. The long loan loss denial was extremely damaging. Now, the crunch issue is who pays the bill. This is a political issue. It is unreasonable and wrong to expect the Irish public to pay the entirety of the bill for the bad investments of European banks. The Irish bank rescue will add at least 40 per cent of gross domestic product (GDP) to Ireland's debt burden. To put this into scale, it's the equivalent of expecting German taxpayers to provide over €1 trillion to foreign banks to protect their solvency. It's the equivalent of French taxpayers paying over €800 billion to foreign banks to protect European financial stability. The German and French people wouldn't tolerate this. They would insist on burden sharing and write-downs. If the ECB doesn't agree to a realistic and fair solution, we have to ask whether it's time for Ireland to take firm action.

The European attitude to burden sharing with the private sector is schizophrenic. European leaders insist that purchasers of Greek government bonds must face the consequences of their poor choice of investment. There will be a write-down of 50 per cent on Greek government bonds. Speaking out of the other side of their mouth, European leaders insist that purchasers of Irish bank bonds must be protected from their poor choice of investment at all costs. Those who invested in an insolvent Greek state must share the pain whereas those who invested in insolvent Irish banks must be repaid in full with interest. There is no economic or moral logic to this whatsoever. The problem is not economic, it's political. The Irish government is being forced, under duress, to repay the bank bonds because many European banks are as stable as a house of cards.

Banks increased the risks that they took with their customers' savings in the hope of making more profit. If all the depositors of any bank in the world wanted to withdraw all their savings on one day, the bank would collapse. Banks do not have their customers' savings. They have lent them out to make profits on loans. Banks do not retain their customers' deposits in cash balances. They lend most of the deposits out by making loans to customers in order to make profits. In order to meet the normal calls by customers on their deposit accounts they retain a fraction of the overall deposits, called the fractional reserve, and only lend out the balance. Over the centuries, banks established tried and tested prudential principles of having a fractional reserve rate at least 10 per cent of their customers' deposits and only lending, safely, the other 90 per cent. Unfortunately, these rules were well and truly thrown out the window during the recent hyper credit bubble years and not just in Ireland.