Revoke the guarantee for the banking system and then convert senior and subordinate bondholders into equity holders
THE DEAL is done, but there is no joy. The agreement that was supposed to end the financial crisis gave rise to its next wave. We are now in the unique situation that financial markets are taking a longer term view than national governments.
The governments are saying: There is no liquidity crisis. Greece and Ireland are safe for the next few years.
The markets are saying: There is a solvency crisis; there is no way that Greece and Ireland will be able to prevent an explosion of their national debt.
The markets, for once, are correct. At an interest rate of 5.8 per cent, the loan from the European Financial Stability Facility will at best plug a temporary funding gap. It will not improve – and quite possibly worsen – Ireland’s underlying solvency position. The interest rate is very likely to be higher than Ireland’s nominal annual growth during the period of the loan. And that means that the real value of the debt will increase.
Solvency is not a legal concept. No court will ever declare you insolvent. Solvency is an analytical framework. You are insolvent if you are not able to service your debt in a sustainable way. Solvency depends on the absolute level of debt, of course, but also on your expected future level of income.
Reasonable people might disagree on what that might be. But it is unreasonable to assume that we will simply return to the pre-crisis game, as though this financial crisis was no more than an unwelcome disturbance of the party. The combination of rising market interest rates, rising money market rates, extreme fiscal austerity, a slowdown in the global economy, financial contagion to other parts of the euro zone and contagion to other parts of the financial markets, including the market for corporate bonds, all make it hard to see where a solvency-maintaining growth rate is coming from.
Yes, Ireland is a flexible economy that is extremely open. Unit labour costs in the export sector are falling. So in contrast to Greece, Spain and Portugal, Ireland is improving its competitive position. But we would be kidding ourselves if we believed that anybody, even the world’s most flexible small open economy, can pull itself out of this mess in the current economic climate. The Nordic countries managed to extricate themselves out of a milder financial disaster in the 1990s. But they devalued their exchange rate. And it all happened in a much more benign global environment. If you ignored all the toxic interactions that are currently taking place, you could make a reasonable assumption of continued solvency: A return to modest rates of growth, no further decline in house prices, a further but contained decline in commercial property prices, a government funding rate now capped at below 6 per cent. You impute this into your macroeconomic model, and it tells you that you are solvent.
But this model can never take account of the toxic interactions that go with the generalised loss of confidence we are experiencing now.
In the last few weeks, the toxic force of the debt crisis has become all too apparent. The financial markets push up interest rates, the economy slows, asset prices fall, the health of the banking sector deteriorates further, more recapitalisation is needed, the deficit increases further, interest rates move higher, contagion spreads horizontally to other European bond markets, and vertically to other parts of the domestic financial market.
Any stabilisation plan will have to work in such a mad world. An Irish economist recently accused me of triggering the crisis when I questioned Ireland's insolvency in one of my columns in the Financial Times. Likewise, other people have been accusing Angela Merkel, the German chancellor, of triggering the crisis with her ill-timed proposals for a regime to bail in investors. The European Commission has been accused of triggering this week's panic in Spain because of an ill-timed critical report about the country's economy.
Irrespective of the substance of any such claims, you have got to ask yourself: can this really be a cause of a crisis? The bad timing of a report? Or a newspaper column?
You must be kidding. If the euro zone depended on a column, it would have no future. Any realistic recovery strategy would have to take account of the inconvenience that, forgive my language, s*** happens.
What should be done now? My ideal solution – from the perspective of the euro zone – would be a common bond to cover all sovereign debt to be followed by the establishment of a small fiscal union; furthermore, banks should be taken out of the hands of national governments and put under the wings of the European Financial Stability Facility. That would clearly solve the problem.
If this is not going to happen, what can Ireland do unilaterally now? Is its game over?
I would advise the following course of action.
First, Ireland should revoke the full guarantee of the banking system, and convert senior and subordinate bondholders into equity holders.
I am aware that this would create second-level problems, in pension funds, in other banks, but it would be less costly, and more equitable, to deal with those specific problems on a case by case basis, than to dump the entire cost on the taxpayer.
The Government should then assess its own solvency position on the basis of an estimate of nominal growth of no more than 1 per cent per year for the rest of the decade. That may well be too pessimistic an assumption, but at this juncture it would be more prudent to err on the side of caution than optimism. Given the scale of the financial crisis, and its direct impact on growth, and everything we know from the history of financial crises, the case for a cautious forecast is overwhelming.
Without the load of the banking sector, such an analysis may well conclude that the Irish State is solvent. The result would depend to a very large extent on the success and extent of any bail-in programme, and the ability to contain any fall-out from such action.
If the analysis concludes that Ireland is insolvent, the Government should waste no time, and restructure the debt. Massive pressure from the EU will be brought on Ireland not to do so. But the right answer to insolvency is default – not liquidity support. Let the German government pay for the German banks, and for the recapitalisation of the European Central Bank, which may need to be refinanced under such a scenario as well.
A default would cause havoc, no doubt, and would cut Ireland off from the capital markets for a while. But I would suspect that the shock would only be temporary. With a more sustainable level of debt, and the benefit of a real devaluation, Ireland should be able to pull through this. Once the market recognises that solvency is assured, I would bet international investors would once again be willing to lend. Even Argentina was able to gain funding from investors a few years after its default.
The big question in such a scenario is: Should Ireland stay in the euro zone? I would say, yes it should. Ireland has a sufficiently flexible economy to be able to manage the necessary real adjustment. In a monetary union, you can no longer devalue. The only chance is what economists call a real devaluation – through lower wages and prices.
Germany can do this. Ireland can do this. Portugal, Spain and Greece, even Italy cannot do this. It is an unpleasant adjustment. But as long as it is politically supported, it can be done, and it can succeed.
From an Irish perspective, the best option, of course, would be a leap towards a fiscal union, agreed by all euro zone member states. In the absence of such a leap, the second best option would be a default – banking debt first, public debt possibly later. The smart choice is to default inside the euro zone. It is going happen, sooner or later.
Wolfgang Münchau is an associate editor and columnist of the Financial Times, and president of Eurointelligence ASBL, www.eurointelligence.com. This analysis was written for The Irish Times