What If Ireland Defaults? (5 page)

Parliament must also respond to the growth of the power of the bureaucracy. The chairman John McGuinness of the Committee on Public Accounts writes that:

[O]ver the past 10 years or so, for various reasons, some to do with corruption, power has slipped through the fingers of politicians into the hands of the unelected, who devised and were allowed to operate strategies to ensure they had to answer to the Dáil as little as possible. It is only in recent years that scandals in State and semi-State bodies have revealed the true cost of lack of governance and accountability.
¹⁹

A Fiscal Responsibility Agenda

Ireland's debt problems must be tackled across the board. Fiscal responsibility legislation must limit the borrowing powers of governments. Borrowing is a tax on future generations not now represented in parliament and they therefore require legal and constitutional protection from governments borrowing now for short-term political gains.

A register of lobbyists and their visits to government departments must be maintained by each house of parliament and updated daily. The full Cabinet must deliberate on large applications for state intervention rather than the subgroup at the incorporeal meeting of 29/30 September 2008. A two-thirds parliamentary majority should be required in the case of large rescue operations such as the Irish bank rescue and party whips should not apply in such debates. There should be a new grade of economist in the Irish public service in order to reduce the potential for control of public servants by lobby groups where public servants lack the economic expertise to rebut lobbyists. Whistle-blowers who report malpractice in public spending should have legal protection in the wider public interest. Parliament must assert control over the bureaucracy of the public service by requiring measures of output and parliamentary evaluation of all current spending programmes.

Each spending proposal must include an evaluation of the results of past spending in the field and projections of future returns from additional expenditure. Ireland requires greater standards of accountability in corporate governance in both the public and private sectors. Senior bureaucrats should have a limited right of audience at parliamentary committees but should not retain the present system of passing notes to ministers while technically not present in parliament. The practice of senior civil servants passing notes or whispered advice to ministers in parliament – government by ventriloquist – should cease. A Central Office of Project Evaluation (COPE) should assume responsibility for all capital expenditure from spending departments. Its reports should be published at least one year before any expenditure is incurred and open to full independent scrutiny by parliament. Appointments of secretaries general in government departments and to state boards should be subject to parliamentary scrutiny. Citizens must have direct access to parliamentary debates rather than through image-based reporting. Proposals to transfer even more sovereignty to the EU should be put on hold until it is apparent that Brussels has any advantages over national governments in terms of efficiency and accountability.

The context for Ireland is that the state is spending more than the taxable capacity of the country and the willingness of foreign lending bodies to finance. Sam Roberts captures this context on pages 185–186: ‘“We didn't change the way we provide public services …. We simply shrunk the system.”' The Culliton Review of Industrial Policy in Ireland decided not to endorse any extra spending as requested by various lobby groups.
²⁰
‘Honey, I shrunk the agencies' was the slogan used then in a movement to restore sound public finances. That imperative is now essential.

Ireland has more new parliamentarians in both houses than in any previous parliament. We new parliamentary brooms must now sweep away the debris from widespread failures of governance which brought first the banks and second the entire country to bankruptcy. That is why we have elections.

Endnotes

¹
David Murphy and Martina Devlin (2009)
Banksters
, Dublin: Hachette Books Ireland, p. 7.

²
Chapter 8 of this book, ‘Iceland: The Accidental Hero', p. 146.

³
Rob Wright (2010)
Strengthening the Capacity of the Department of Finance
, Dublin: Stationery Office, p. 44.

⁴
Matt Cooper (2009)
Who Really Runs Ireland
, Dublin: Penguin Ireland, p. 207.

⁵
Chapter 5 of this book, ‘A very Irish Default, or When Is a Default Not a Default?', p. 95.

⁶
Chapter 9 of this book, ‘Irish Public Debt: A View through the Lens of the Argentine Default', p. 154.

⁷
Chapter 15 of this book, ‘A Politician's Perspective on Debt and Default', p. 244.

⁸
Chapter 9 of this book, p. 149.

⁹
‘Houses Built on Sand',
The Economist
, 15 September 2007.

¹⁰
Chapter 10 of this book, ‘Coring out the Big Apple: New York's Fiscal Crisis', p. 186.

¹¹
Sean D. Barrett (2006) ‘Evaluating Transport 21: Some Economic Aspects',
Quarterly Economic Commentary
, Winter, pp. 36–58.

¹²
Special Group on Public Service Numbers and Expenditure Programmes (2009)
Report of the Special Group on Public Service Numbers and Expenditure Programmes
, Dublin: Stationery Office, p. 43.

¹³
Brendan Drumm (2011)
The Challenge of Change: Putting Patients Before Providers
, Dublin: Orpen Press, p. 137.

¹⁴
Ibid
.

¹⁵
James Kirkup (2011) ‘Euro Doomed from Start, says Jacques Delors',
Daily Telegraph
, 3 December 2011.

¹⁶
Conor O'Cleary (2001) ‘US Economist Expounds on Great Euro Mistake',
Irish Times
, 5 September 2001.

¹⁷
Chapter 18 of this book, ‘A Political Activist and Businessperson's Perspective on Debt and Default', p. 274.

¹⁸
Chapter 16 of this book, ‘A Financial Journalist's Perspective on Debt and Default', p. 250.

¹⁹
John McGuinness and Naoise Nunn (2010)
The House Always Wins
, Dublin: Gill and Macmillan, p. 209.

²⁰
Jim Culliton (1992)
A Time for Change: Industrial Policy for the 1990s
, Report of the Industrial Policy Review Group, Dublin: Stationery Office.

2

Crises and Contagion: A Survey
¹

Anzhela Knyazeva
,
Diana Knyazeva
and
Joseph Stiglitz

Anzhela and Diana are assistant professors of Finance at the Simon School of Business, University of Rochester. Their corporate finance research has been most recently published in the
Journal of Financial Economics
. Joseph is a Nobel Prize-winning economist and a university professor at Columbia University. He is a prolific researcher, commentator and author, whose books have been translated into more than thirty-five languages. His most recent book is
Freefall: Free Markets and the Sinking of the Global Economy
(2010). In 2011,
Time
named Stiglitz one of the 100 most influential people in the world.

Introduction

Financial and economic crises and contagion are the subjects of a vast body of macroeconomic and finance research. Many recent interventions by national governments and multilateral institutions, such as the International Monetary Fund and the European Central Bank, sought to stem the spread of contagion. In September 2008, motivated by concerns about a run on the banking sector, the Irish government provided a two-year guarantee for the debt and deposits of major Irish financial institutions such as Anglo Irish Bank, AIB, Bank of Ireland, and several others. Major Irish banks, including Anglo Irish, had been experiencing deposit outflows and short-selling by institutional investors concerned about the spread of global financial turmoil and the crisis in the Irish property market. At the time financial regulators deemed it to be an illiquidity, not an insolvency, issue (
Wall Street Journal
, 2010).
²
The introduction of a government guarantee to the banking sector was expected to stem the confidence crisis and signal to capital markets a reduced chance of default, avoiding costly bank failures. The magnitude of the bad loan problem came to light in subsequent quarters. Amidst widening losses on property loans, the Irish government nationalised Anglo Irish Bank and subsequently provided capital to the bank. The Irish government formed the National Asset Management Agency (NAMA), which took land and construction loans off bank balance sheets in an effort to shore up major banks.
³
Over the next two years, the government would inject an estimated total of €46.3 billion into the banking system, including €29.3 billion into Anglo Irish Bank (
Wall Street Journal
, 2011). The costs of the bank sector rescue led Ireland to negotiate an ECB/IMF bailout. The final tally of bailout costs is likely to be larger due to recessionary pressures stemming from fiscal austerity measures (Stiglitz, 2010a).

Before assessing the effectiveness of interventions or designing a global financial architecture that limits the spread of contagion yet takes advantage of the benefits of integration, we need a rigorous understanding of the mechanisms behind crises and contagion. Below we provide a survey of the existing theories of financial crises and contagion. We conclude by discussing the implications of contagion for economies with open capital markets, illustrated by recent global financial crises in East Asia, the US and Ireland.

Economic crises are defined as a sudden downturn in the level of economic activity, accompanied by an increase in unemployment rate and bankruptcies. Financial crises are typically associated with a sudden fall in the exchange rate or stock market prices. Banking crises are characterised by credit contraction, increase in defaults, and even bank runs and bankruptcies. Typically, the various crises are related (both temporally and causally): an economic crisis (whatever the cause) typically leads to a stock market downturn and a weakening of the exchange rate; and banking and financial crises typically lead to economic crises.
⁴

This survey is written from the vantage point of hindsight provided by the recent global financial crises. Several earlier theories of crises provide little insight into those crises, while other explanations have proven to be more relevant. In any case, the recent global financial turmoil provides a new lens through which one can see crises more generally. For instance, standard interpretations of the East Asian crisis emphasised weak institutions and a lack of transparency, and suggested American institutions as an alternative model, which presumably would reduce, if not eliminate, the incidence of crises. We now realise that whatever is meant by ‘transparency' and ‘good institutions' is more complicated than was widely thought at the time; in particular, it became evident that there were major deficiencies in governance and in transparency in American financial institutions, both the private institutions and the public ones that were supposed to regulate them. While some commentators had predicted a crisis, based on persistent global imbalances, the recent financial crises in the US and Ireland were not caused by those imbalances, but at least precipitated by the bursting of the housing bubble. For years the Celtic Tiger growth had been backed by solid fundamentals, including investments in infrastructure and human capital, and productivity growth. Like the US and many other markets, Ireland also witnessed a property boom facilitated by low interest rates and easy access to bank loans. As long as investors pursued leveraged bets on the real estate sector, helping to sustain the growth in residential and commercial property prices, default rates on loans remained low. Consequently, banks enjoyed rising equity valuations and low yield spreads. However, as interest rates increased and investor sentiment weakened with the onset of the global financial crisis, the property market collapsed, bank loan losses mounted and major banks became undercapitalised.

Standard models based on previous crises attempting to predict vulnerability to crises would have suggested that the US and Western Europe were not vulnerable. This is, in a sense, in keeping with the long tradition of crises, where each crisis seems attributable to factors that were not singled out as ‘explaining' the previous. Indeed, according to the conventional wisdom, where flawed macroeconomic and monetary policies were often cited as playing a key role in the generation of crises, the US and Europe were given high marks.

There is a large literature on crises and contagion. This survey focuses on the theory, and in particular on how to reconcile crises with standard neoclassical theory and macroeconomics. Crises present a number of puzzles for standard economic theory. While some of the models discussed below resolve some of these puzzles, none to date does so in a fully satisfactory way, or at least in a way which is consistent with much of prevailing finance and macroeconomics:

• A distinguishing feature of most financial crises is a sudden change in the exchange rate. While outside observers may have expressed continuing worries, say about an overvalued exchange rate, the exchange rate adjustment process does not appear to work smoothly (in contrast to standard forward-looking models with rational expectations, where individuals gradually revise expectations in light of the steady inflow of information; typically, there is no new information of a magnitude that should have led to a readjustment of exchange rates of the magnitudes observed). This is an example of the more general puzzle of crises: large changes in outcomes that seem incommensurate with the scale of changes in the underlying state variables (see Stiglitz, 2011; United Nations, 2010).
  
• Standard models suggest that diversification – the spreading of risk around the world – should have led to a more stable economic system. The 2008 crisis suggested the contrary: diversification helped spread the crisis. There is a growing consensus that diversification may reduce the exposure to small crises, but increase that to larger ones. As more countries liberalised their capital markets, global capital and interbank linkages became more prevalent. Countries around the world experienced spill-overs from the US financial crisis. Irish banks had relied heavily on global interbank loans prior to the crisis. When short-term interbank lending froze up in the third quarter of 2008, Irish banks faced significant funding constraints.
  
• Conventional theories imply that even in markets where there is some irrationality, all that is required to make markets work well (to make markets reasonably stable and efficient) is that there be enough (and enough may be a relative notion) rational market participants.
  ⁵
  The empirical evidence (buttressed by this crisis) is that rational participants exploiting the irrationality of others may make the markets highly volatile.
  
• After the crisis there is a focus on contagion – on how interdependence can lead a crisis to move from one country to another; but before the crisis there is an emphasis on the benefits of diversification, on how interdependence enhances stability. None of the prevailing models integrates coherently these opposite forces (with the exception of Stiglitz, 2010b, 2010c).
  
• Policy frameworks have been equally incoherent. The standard response to contagious diseases is quarantine – the equivalent of capital controls. But many in the international community have resisted the imposition of capital controls, even in the event of a crisis.
  
• Policy decisions have often entailed interventions in the market that are announced to be (or believed to be) temporary, but it is argued that they will have long-run effects, shifting the equilibrium in the countries suffering from contagion. Why such temporary interventions would have long-run effects is often not clear (Stiglitz, 1999a).
  

A central thesis of this survey is that understanding crises requires an understanding of market imperfections – and especially of the constraints, for instance, on borrowing, imposed by imperfect information – and how those market imperfections interact with irrationalities on the part of market participants and imperfections in the regulatory environment.

In the discussion below, we follow the literature on crises through its various stages, motivated by the series of crises the world has experienced in the last three decades. In retrospect, however, there is a basic taxonomy:

• Models in which the shock giving rise to the crisis is exogenous, and those in which it is endogenous
  
• Models in which markets are fully rational, and those in which they are not
  
• Models in which there are multiple momentary equilibria, and models in which there is a unique momentary equilibrium
  
• Models in which there is a unique steady state (long-run) equilibrium, and models in which there are multiple long-run equilibria
  

The logic of crises is simple: if there are multiple momentary equilibria, then the economy can suddenly switch from one to the other without any large change in any state variable (other than beliefs, which themselves are treated as state variables). If there are multiple steady state equilibria, then a shock to the state variables of the economy (whether endogenous or exogenous) can act as a tipping point, bringing the economy into a different ‘orbit of attraction'.

So too, the mathematics of crises is simple: under the convexity assumptions made in most economic models diversification spreads risks and reduces their impact. But, as Stiglitz (2010b, 2010c) points out, non-convexities are pervasive (bankruptcy, learning, etc.), and with non-convexities diversification can amplify systemic risk.

This paper is divided into three sections. The first surveys the literature on what causes crises; the second on contagion and the effect of interdependence in amplifying crises; the third on the role of government. Not surprisingly, theories which stress the efficiency and stability of markets look to government as the source of the problem; stability is attained by government not interfering in the natural workings of the market. Theories which see the economy as inherently inefficient and unstable look to government to help correct market failures.

Ascertaining which of these theories is correct is not easy, and beyond the task of this short survey. One of the reasons for the difficulties is that there are elements of many of the alternative approaches present in every crisis. No one could look at the recession of 2008 or the Irish banking crisis without noting market irrationalities. But does that mean we could not have had a crisis in the absence of such irrationalities? The major shock was an endogenous one – a housing bubble; the shock was not an exogenous event (‘a once in a hundred year flood'), but there were exogenous (at least to the economic system) events that perhaps could have triggered a major downturn, reflected in the spike in oil and food prices.

What Causes Financial Crises?

The earliest approaches to the onset of currency and financial crises – the first generation of crisis models – focused on fundamental macroeconomic imbalances and adherence to a monetary policy incompatible with the maintenance of an exchange rate peg (for example, Krugman, 1979).
⁶

The 1994–1995 Mexican crisis led policy makers to ask what accounted for the sudden onset of a market panic. Although fundamental macroeconomic problems, including overvalued exchange rates, current account deficits and rising short-term foreign currency government debt, were present, the peso's devaluation alone did not quickly stem the crisis.
⁷
The crisis (like many before it) posed several questions: (a) why did it occur when it did? The fundamental imbalances had long been recognised, and (b) the large immediate fall in the exchange rate, which many thought should have equilibrated the market – leading to what might be viewed as an equilibrium exchange rate – didn't stem the crisis. Why not?

The peso crisis led researchers to turn their attention to information flows and trader behaviour around market panics, which formed the second generation of theories of currency crises (for example, Sachs, Tornell and Velasco (1996); and Agenor and Masson (1999); and more informal discussions by Furman and Stiglitz (1998); and Stiglitz (2010b)).