What If Ireland Defaults? (20 page)

When it became manifest that this external financing was not forthcoming other measures were required to deal with the inevitable collapse of Iceland's financial system. The country's fortune paradoxically is that in these circumstances the government had zero credibility and the banks were considered to be so toxic that no one was willing to offer financial backing or assurances. It was at this moment that the Icelandic authorities realised that saving the banks was virtually impossible and measures would be needed to minimise the impact of their collapse on the state and on Iceland's economy.

Emergency legislation was rushed through the Althing, Iceland's parliament, which gave the financial services authority and the government unprecedented powers to intervene in the financial markets by, for example, moving domestic deposits, loans and assets into new banks. Most of the foreign loans and assets were left in the old banks and they went into administration. The CBI lost most of the loans it had provided to the old banks, which is an amount equivalent to 13 per cent of Iceland's GDP. Effectively the CBI went into bankruptcy, which is another peculiarity of the Icelandic case. A similar amount of money went into establishing the new banks that took over the deposits, loans and assets of the old banks. The government received a stake in the new banks which since then is estimated to have gained in value. So that does not constitute a loss of taxpayers' money as the bankruptcy of the CBI undoubtedly is. The state could always get some of its money back if it decided to sell its stake in the banks.

The emergency legislation came about because all other routes were closed for Iceland and it is since then an important ingredient in the country's recovery, mainly because of two factors. The first is that the taxpayer was not put at further risk by the financial system. As already explained, the loss of taxpayers' money was considerable but the emergency legislation resulted in the old banks going bust. It meant losses for the creditors of the banks but that is how it should be as they were responsible for lending to the banks. The second is that the country's external debt was minimised. Instead of having a banking sector that was ten times the country's GDP the new banks amounted to twice the value of Iceland's GDP. The difference is vast and is extremely important in the volatile financial climate in the Eurozone.

Ireland's path is considerably different in this respect. The Icelandic banks were too big to save. Although the same ultimately proved true in the Irish case, it took three years to reach this realisation. The Minister for Finance, Brian Lenihan, determined in 2008 that Anglo Irish Bank was of ‘systemic importance to Ireland' because of its €100 billion balance sheet. The bank, Lenihan said, ‘had grown to half the size of our annual national wealth, so clearly the failure of a bank on that scale would do huge damage to the local economy here in Ireland.' This is a view shared by the Governor of the Central Bank, Patrick Honohan, in his 2010 Banking Report. Honohan argued that if Anglo had been allowed to default it ‘would undoubtedly have put funding pressure on the other main Irish banks via contagion …. In this sense, the systemic importance of Anglo Irish Bank at that time cannot seriously be disputed.'
⁸

In addition, Ireland received backing to support its banking system from the troika of the ECB, the IMF and the EU. Therefore, unlike in the Icelandic case, the banking system remains oversized and what may even turn out to be worse is that taxpayers' money is what has sustained its size. The question is, of course, whether Ireland should have done something similar to the emergency legislation enacted in Iceland and watched the banks go into administration but rescue assets that were of national interest?

In our opinion such drastic measures may not have been needed but neither was it necessary to back the entire financial system. Ireland's financial system did not achieve the size of Iceland's when compared in terms of GDP but many of the same factors contributed to its growth, such as extensive borrowing that fuelled a housing bubble, excessive consumption and contributed to an overall growth in the economy in the short term. This means that there are severe inherent weaknesses within the Irish financial sector that the National Asset Management Agency (NAMA) initiative may not be able to isolate and resolve so that the sovereign is adequately protected. The Irish authorities should rather have considered a policy that did defend all of the banks but let the riskier ones go bust, and moved certain assets into other banks that were deemed necessary to rescue from a financial stability point of view. Such a move would have minimised the exposure of the taxpayer and downsized the financial system effectively, which is what Ireland needs.

Iceland initially tried to salvage its oversized banking sector but in the end received no backing for such a move and was forced to use other means to tackle its crisis. These measures have since led the country to become an accidental hero. In retrospect this turned out to be good fortune for Iceland and has helped with the resurrection of its economy. It is, however, important to remember that Iceland incurred severe costs because of the financial crisis. Although Ireland should have not followed Iceland's path completely, one can argue that it would have made sense for Ireland to use a pick and choose policy as to which financial institutions were worth saving. It may seem strange to say this but what seems to be Ireland's misfortune in this regard is just that the Irish banks were not big enough for policy makers to deem it virtually impossible to salvage them. Instead the decision was taken to bail them out because saving them was deemed ‘manageable', and that may turn out to be a very difficult route to take. As Professor Morgan Kelly forlornly noted in an
Irish Times
editorial in May 2011, ‘While most people would trace our ruin to the bank guarantee of September 2008, the real error was in sticking with the guarantee long after it had become clear that the bank losses were insupportable.'

Public v Private – The Fate of the Sovereign

When countries are faced with the question of whether it is sensible to bail out banks immediate questions are raised about sovereign default. This can be seen in both the Irish and Icelandic cases and in other instances as well. This is one of the peculiarities of the current financial crisis in that financial institutions which are in principle private entities are linked to the sovereign if they are thought to be close to insolvency. During the boom years, when the banks provided handsome dividends to their stock owners and large staff bonuses on top of high wages, little attention was paid to the implications of financial institutions in crisis on public funds. Any critique of big salaries and bonuses was dismissed because the banks as private entities could decide how much of their profits they allocated to meet the demands of their top-level staff.

In the aftermath of the financial crisis it seems, however, that either it was always tacitly assumed that the sovereign backed banks in trouble or few people imagined that they would get into a crisis and difficult questions were never asked. It is clear that the lack of preparation and denial of the severity of the situation within the financial sector in many countries has cost many nation states dearly and also the Eurozone as a whole.

In our view the onus of justification is always on those who want to use public funds to keep a financial institution in business. There are often strong arguments for bailing out banks because it can turn out to be more expensive for an economy not to do so. Nevertheless, those arguments start to lose their appeal in countries with oversized financial institutions that are systematically failing. Then a clear divide needs to be made between private entities and the sovereign. The lesson from Iceland is that if Iceland had been able to continue to finance its banks in 2008 with public funds the sovereign would have probably ended up defaulting, with devastating consequences.

Ireland, like other western democracies, has been captured by big finance but is not cognisant of this reality because moral outrage has been directed towards isolated scandals in the market and unjustified bonuses for individual bankers. It is supposed that the economic collapse is a problem intrinsic to the weaknesses of regulation and the hubris of bankers and property developers. The capture of the state by an oligopolistic financial sector, due to excessive risk taking without consequence, was complemented by the failure of political institutions to anticipate the collapse.

The result from Ireland remains to be seen in the context of a rapidly escalating Euro crisis. The justification for the measures taken in rescuing banks then regarded as of ‘systemic importance to Ireland' has become emaciated and unconvincing over time. The fears of contagion amongst financial institutions within other EU member states are understandable and logical. However, if that is the case then the problem ceases to be a problem. The assumption that the Irish taxpayer should exclusively shoulder the burden of private debt is also a problem for those whom they are saving. The weights should be lifted equally by those affected. Otherwise the task becomes too difficult. And
unmanageable
.

Endnotes

¹
Minister for Finance, Mr Brian Lenihan, ‘Returning to Economic Growth: The Next Steps', Address to the Irish Taxation Institute Annual Dinner, 26 February 2010, available from:

.

²
IMF (2011) ‘IMF Completes Sixth and Final Review Under the Stand-By Arrangement for Iceland', Press Release No.11/316, 26 August.

³
Poul M. Thomsen (2011) ‘How Iceland Recovered from its Near-Death Experience',
iMFdirect
, 26 October 2011, available from:

.

⁴
International Monetary Fund (2011) ‘Iceland's Unorthodox Policies Suggest Alternative Way Out of Crisis',
IMF Survey Magazine: Countries & Regions
, 3 November 2011, available from:

.

⁵
iMFdirect
(2011) ‘No Country Is an Island: Ireland and the IMF', 14 July, available from:

.

⁶
Organisation for Economic Co-Operation and Development (2011)
OECD Economic Surveys: Iceland
, Paris: OECD.

⁷
Arthur Beesley (2011) ‘Leading EU Official Says State Bank Guarantee a Mistake',
Irish Times
, 17 June.

⁸
Patrick Honohan (2010)
The Irish Banking Crisis Regulatory and Financial Stability Policy 2003–2008: A Report to the Minister for Finance by the Governor of the Central Bank
, Dublin: The Stationery Office, p. 131.

9

Irish Public Debt: A View through the Lens of the Argentine Default

Tony Phillips

Tony is a researcher at the University of Buenos Aires and a journalist in political economics. His website is
http://projectallende.org/
.

Reckless financing in the Irish construction industry combined with a lack of enforcement of national banking regulations with cheap Eurozone credit financed twenty years of Irish economic expansion. An overshoot in loan activity exposed both local and international financiers to speculative loans at the end of a prolonged real estate bubble. When the bubble burst the overextended construction sector collapsed, defaulting on its loans. This destabilised the Irish financial sector, resulting in the insolvency of almost all Irish private banks. Then came the rescue ….

This is the story of how one Irish government reacted to the 2008 financial collapse looking at choices yet to be made that will determine what happens next. The point of view is South American. South American debt initiatives are presented in an effort to determine their applicability to debt accrued in the financial rescue, the legacy of a Fianna Fáil coalition voted out of power in 2011. Here in Buenos Aires just a decade ago the Argentine economy imploded in a sovereign debt crisis. For Argentine economists, hindsight is 20/20. The good news from South America is that a number of non-conventional negotiation tactics can provide legal and tactical armour to a sovereign Irish government willing to defend itself against the debt markets. There is still time for Ireland to incorporate new ideas that can prevent an uncontrolled sovereign default, unnecessary payment of illegitimate debt, or both.

Stepping Up to the Plate

The Irish sovereign debt problems can be solved through hard work. First the new government needs to accept that there is a problem, and then the problem needs to be broken down to its essentials, determining its origin, and, finally, the problem can be dealt with in a proper timeframe.

Translating this to the case in point – any new government needs to admit that Ireland has a sovereign debt problem. This may sound ridiculous but such an admission can be politically difficult, especially when dealing with financial markets. Government denial and cover-up were the unhealthy reactions evident in Argentina in the late 1990s just before the economic collapse. Next up comes financial investigation: positive initiatives like the audit produced in the University of Limerick.
¹
Armed with this type of information the new government can determine how the debt came to be and who is responsible for creating it. This helps determine its legitimacy. By separating out illegitimate debt, the nominal debt may be reduced to that which is really essential to pay. Finally, having apportioned blame and begun prosecution of those responsible, one can begin the tough international negotiations to come to a just agreement with creditors. That done, all that remains is to pay off the reduced amount over a reasonable period of time.

During the recovery expert help and solidarity measures from partners can be crucial. The Argentine recovery, which began in 2003, would have been much more difficult were it not for timely solidarity funding from friendly governments.

Last but not least, one has to recognise that sovereign debt is a national sovereignty issue. Any government elected by the Irish people has to be willing to represent the sovereign interests of the nation. Failure to do this questions the sovereignty of the state itself.

Save the Banks!

In 2008 the Irish government scrambled to avoid a national financial collapse of the private banking sector. This involved some extraordinary decisions in the rescue of the insolvent financial system; decisions that were made by the Department of Finance and the Central Bank of Ireland.

A subsequent government enquiry into this rescue led to the production of a report to the Minister for Finance by the Governor of the Central Bank entitled ‘The Irish Banking Crisis Regulatory and Financial Stability Policy 2003–2008.'
²
The conclusions of this enquiry are critical of the government rescue. In particular, they argue:

The inclusion of subordinated
³
debt in the guarantee is not easy to defend against criticism. The arguments that were made in favour of this coverage seem weak: And it lacked precedents in other countries …. Inclusion of this debt limited the range of loss-sharing resolution options in subsequent months, and likely increased the potential share of the total losses borne by the State.

Subordinated debt is debt that a state does not usually pay when rescuing an insolvent banking sector. The handling of the 2008 financial emergency was unnecessarily generous. It resulted in a wholesale conversion of private bad debt (on the books of Ireland's private banks) into government guarantees and public debt obligations for which the Irish taxpayer has ultimately been made responsible. Ireland is not the only nation that faced such a financial collapse; similar financial instability is evident across Europe and elsewhere. The Irish rescue has since been compared with other rescues internationally, notably by Joseph Stiglitz and William K. Black.

Nobel Laureate and former chairman of President Clinton's Council of Economic Advisers Joseph Stiglitz compared some of these financial rescues. He describes the Irish rescue as ‘probably the worst model', adding that ‘Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks.'

In an Irish radio interview on 15 February 2011, William K. Black, a key regulator and prosecutor in the savings and loans scandal in the United States, was even more emphatic as to the mistakes made in Ireland. Commenting on the parallels between the savings and loans bank rescue and the Irish rescue, he said:

… the whole concept of subordinated debt is that it is supposed to serve as risk capital. And so if the bank fails it is supposed to get nothing …. Every regulator knows that ….

Commenting on the Irish rescue, Black derided the generosity of the decisions made:

We'll pay the subordinated debt holders with the Irish taxpayers paying the money! And of course without asking the Irish taxpayers. It is the most obscene policy. … We've looked at lots of other countries and nobody has responded to a crisis as stupidly as the Irish government responded. It just gratuitously took billions of Euros from the Irish people to give it to mostly German banks who had no right at all under the laws. They were supposed to lose that money if the bank failed. That was the deal they made.

Feedback on the Rescue

On a visit to Dublin in 2009 I was asked, ‘What's the difference between Iceland and Ireland?' ‘One letter and six months' was the witty response. Sadly this was not to be the case. In Ireland the banking rescue took much longer than six months to be resolved; in fact it is not over yet. The financial problems have simply been shifted to the public sector. Ireland, unlike Iceland, did not collapse with a bang; it limped on with a whimper. The collapse of the banks in Iceland resulted in vast losses across the world and wholesale bankruptcy of the Icelandic banks. In Iceland the financial problem was so big it could not be solved; so it wasn't solved. Local and international creditors took their losses, licked their wounds and tried to litigate for their money. Iceland is still in the process of recovery. In two national referendums Icelandic citizens said no to payments to foreign creditors, especially those in the UK and the Netherlands, but the cost of trying to rescue its local banking sector is still high and political unrest continues.

Public opinion in Ireland in 2011 is reluctant to make comparisons with Iceland. Maybe it should. The scale of the collapse of the Irish financial sector should not be underestimated. Michael Lewis, in his
Vanity Fair
exposé ‘When Irish Eyes Are Crying', cites Theo Phanos, a hedge fund manager working in London at the time, who called Anglo Irish Bank ‘probably the world's worst bank; even worse than the Icelandic banks.'

His opinion is supported by the British Independent Commission on Banking Report
⁴
published in September 2011. In Figure 4.4 of this report, entitled ‘Losses suffered by banks in the crisis as a percentage of (RWA) risk-weighted analysis', Anglo Irish Bank was the worst bank in Europe, ‘making the greatest cumulative loss over the period 2007/2010' by this measure.

In 2008 Ireland had a largely insolvent financial sector, as did Iceland, but the Irish government's handling of the problem was to shift most of these problems onto the shoulders of its taxpayers and trundle on. This is more akin to Argentina in the 1990s than to Iceland in 2008. In 2011 Iceland began to recover: it issued new sovereign debt at rates of about 5 per cent annually. Argentina had an even harder default in 2001–2002. Argentina is taking longer to recover but it is now on its way. The new Irish government inherited a mountain of sovereign debt; this still lies between Ireland and economic recovery.

Generous to Whom?

The Irish government began a sequence of costly rescue attempts of the private financial sector in 2008. It proved incapable of solving the problems in the Irish banks on its own. A tsunami of private bad debt overwhelmed government finances. The piecemeal nationalisation of the Irish banks was expensive. Irish banks had already sold off many of their best assets in an attempt to avoid nationalisation. The government used off-balance sheet mechanisms to obfuscate the scale of the problem, including the 2009 creation of NAMA (the National Asset Management Agency). NAMA is a ‘bad bank' vehicle specialising in property. Since Ireland's principal financial debt problems resulted from property speculation, NAMA represents a big part of Ireland's financial problems. The end result of the rescue was the generation by various mechanisms, including bank guarantees, of what Standard and Poor's (S&P) estimate is €90 billion in new sovereign debt (counting likely future losses in NAMA).

By rescuing Ireland's banks the Irish government also let the Irish banks' creditors off the hook. The money for the property loans loaned out by Irish banks was in turn borrowed from British and European private banks. The European banks insured many of these loans to Irish banks with ‘swaps'. A swap is an unregulated insurance policy, a financial product invented by the derivatives financial sector that is concentrated in the US. If the Irish banks had been allowed to default on their creditors, the European banks that loaned them the money could have
called in
the swaps (asking for payment).
⁵

The US government salvaged its own financial sector in a similar manner with the 2008 rescue of American International Group (AIG). AIG was a major holder of swaps on debt, including sub-prime mortgages. The buck stopped with AIG, so the US government saved its derivatives sector by saving AIG, which in turn saved its banking sector that had leveraged the ability to generate swaps to ‘securitise' debt. The Irish government's wholesale rescue was apparently considered necessary to save the Irish banks but it had the side effect of plugging a hole in the dyke that threatened to drown the swap holders as well. Timothy Geithner answered questions on this matter in the Senate Banking, Housing and Urban Affairs Committee hearings where he discussed the systemic risk that the private European banking sector posed to the US financial sector in question time during the 2011 Annual Report to Congress of the US Financial Stability Oversight Council.

Apart from systemic risk factors, there is the issue of personal responsibility. In Ireland, executives of some major banks failed to declare secret loans that their own banks had made to them personally. For example, the former chairman of Anglo Irish Bank, Sean FitzPatrick, hid an €87 million loan even from his own shareholders. Mr FitzPatrick was arrested but then released. Other individuals absconded from the country without paying back the debt to their own failed banks. Again the apparent attitude of the Irish government is that the Irish taxpayer should take the hit for apparent corruption.

Calling in the Multilaterals

In early 2011 the Irish government rescue effort was finally overcome. The
go it alone
attempts to fix its broken banking sector did not work. The Fianna Fáil government called for help from multilateral lenders, principally the European Central Bank (ECB), the ECB's new rescue fund (part of the European Stability Mechanism – the ESM) and the International Monetary Fund (IMF).

These multilateral banks endorsed the generous Irish rescue and provided short-term liquidity (funding to keep the Irish banks solvent) at a healthy interest rate. This gave the exposed Irish, European, US and other private financial institutions a chance to offload bad Irish debt. Bad loans were converted into loans and liquidity from the multilaterals for which the Irish government provided guarantees. The rescue left the Irish taxpayer with massive debt liabilities and interest to repay as a result of minimal write-downs on the debt. The new debt added further stress to Ireland's economy, now plunged into a deep recession. Ireland became a member of the Highly Indebted Rich Countries club (HIRC) joining four other European members: Greece, Portugal, Italy and Spain. The global financial industry refers to these five European debtors as the ‘European Peripherals'. Global bond markets launched a speculative attack on the bonds of all five nations. This compounded their debt problems, raising the ante, and creating a regional sovereign debt crisis.

Passing the Buck

A transfer of political power during an economic crisis – loading the new government with the problems caused by the previous government's financial mismanagement – is all too common in South America. Such a transfer of political power has already happened in Ireland, Portugal, Greece and Italy. Inheriting such a situation is not easy; resolution often implies a break with previous policies.