What If Ireland Defaults? (22 page)

The Ecuadorian government began a sovereign debt audit under a presidential decree signed in the National Palace in Quito on 9 July 2007. President Rafael Correa had just been elected. He had run on a platform that included debt renegotiation. He created the Commission for an Integral Audit of Public Debt (CAIC in Spanish).
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The idea of a national debt audit is simple: pare back the nominal public debt to the essential debt that the public is legally obliged to pay. To do this it is necessary to audit the legitimacy and the source of the debt. The CAIC audit committee was made up of a team of government, religious and civic representatives, with both national and international participation. The Ecuadorian sovereign debt audit was followed by active debt restructuring. Reuters journalist Felix Salmon analysed the first phase of this restructuring in an article entitled ‘Lessons from Ecuador's Bond Default' in May 2009. He cites Hans Humes, of Greylock Capital, who describes the Ecuadorian strategy as a ‘great blueprint now of how to do it.' Humes called it, ‘one of the most elegant restructurings that I've seen'. The bond dealers were sanguine; the party was over! ‘The world has changed,' said Humes:

… we're now living in a world where not only Ecuador can default, but Iceland can default as well. And that's a world where defaults by small emerging-market countries simply don't have the systemic consequences that everybody thought they might have.

More information on the CAIC is available in the excellent Greek documentary
Debtocracy
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and the final report of phase one of the Ecuadorian debt audit (published in English in 2008) is downloadable from the government website

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Eric Toussaint of the Committee for the Abolition of Third World Debt (CADTM) was a consultant to the Ecuadorian CAIC audit in the sub-committee on multilateral debt. He argued in an article on 25 August 2011
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that much of the peripheral unproductive (rescue) debt should be declared illegitimate. His argument goes as follows:

It is obvious that the conditionalities imposed by the Troika
¹⁰
(massive layoffs in the civil service, the dismantling of social protection and social services, reduction of social budgets, increase in indirect taxes such as VAT, the lowering of the minimum wage, etc.) violate the UN Charter.

[…] It takes us back to a question raised by the doctrine of odious debt: who benefits from the loans?

Option Two: Solidarity Finance

Another unconventional option for governments out of favour with the debt markets is to seek solidarity finance. In Ireland's case solidarity might be found within the European Union. Solidarity could preferably be coordinated with the other ‘peripherals' like Greece and Portugal.

For a long time now the EU has been much more than just a common market. The EU is a political, monetary, economic and military community of nations. In fact it used to be called the European Community. It is in the interests of all community members to prevent a fellow nation's financial collapse, especially when most European nations have private banks that are (or were) bondholders of peripheral debt. Negotiating solidarity measures makes sense: it is part of being a good neighbour. It could demonstrate to the debt markets that speculative attacks would be unprofitable.

The ECB is currently providing essential liquidity to the Irish banks, thus bridging the transfer of risks from private European banks to community taxpayers (at the cost of Irish government guarantees). An argument could be made that some of this cost should be socialised to the community itself. Various suggestions have been made to do this including Eurobonds (EU bonds backed by institutions of the European Union, not national bonds denominated in Euro).

In late August 2011 Christine Lagarde, the new director of the IMF, had another suggestion. At the US Federal Reserve Symposium in Jackson Hole, Wyoming, Lagarde said, ‘European banks may need forced capital injections to stop the spread of the Eurozone's sovereign and financial crisis.' In a curiously circular argument she added that European private banks would need this infusion of capital to ‘[be] strong enough to withstand the risks of sovereigns and weak growth [thereby] cutting the chains of contagion.' Lagarde suggested that the private sector could take its share of losses but also added that an injection of funds might have to come from public European sources:

One option would be to use the European Financial Stability Facility to make direct capital injections into banks [so as to] avoid further stress on the finances of national governments such as Greece.

Presumably Christine Lagarde would also include Ireland in the list of peripheral governments with stressed financials, but Ireland is somewhat unique as much of the Irish sovereign debt (and guarantees) is the direct result of the rescue of Ireland's private financial sector. Lagarde suggests that private European banks need to have capital injected into them by the European Financial Stability Facility (EFSF) so that they can improve their resilience to sovereign risks. In Ireland's case it is too late to do this; in fact the Irish ‘sovereign risk' is the result of the private rescue. It could be argued that this new ‘Lagarde doctrine', if put into effect, would imply that the EFSF should intervene after the effect in Ireland's case.

After the abrupt departure of Dominique Strauss-Kahn, Lagarde became the first female managing director of the IMF, having served as Finance Minister of France from 2007 until July 2011. The IMF is, as its name implies, an international monetary institution tasked with global financial stability (both private and public banks). Her call to save the private banks with public money in order to prevent risks to private banks from public defaults is a somewhat circular argument. In layman's logic it is somewhat absurd but the financial world has its own logic. It does not mean that, if implemented, the plan would not work.

Lagarde's idea to use the EFSF to protect Europe from a default on sovereign debt could be considered a call for an EU solidarity measure. In retrospect, implementing Lagarde's suggestion in Ireland's case would imply the use of European funds to rescue the private Irish banks (as against Irish state funds and guarantees). If the EFSF had intervened as Lagarde suggested in Ireland the Irish sovereign debt crisis would have been avoided altogether.

In other words, one way to save Ireland from default is to socialise the pain of rescuing the Irish financial sector. A transfer from the ESM could be used to partially eliminate the state guarantees and thereby pay down the sovereign Irish debt from the blanket rescue. The private sector could also be forced to share the pain. A default would be avoided. Problem solved! One could argue that Lagarde's suggestions give Irish negotiators further leverage in negotiations with creditors in Brussels and Frankfurt. The Irish, the Greeks and the Portuguese might even ask the IMF to broker such a deal. The fact that this announcement was made from Jackson Hole would lead us to believe that such a solution would be acceptable to Washington as well. It is an alternative means to rescue US holders of swaps at Europe's expense.

Regional solidarity was important to Argentina too. Unfortunately this solidarity came only after the political collapse when the new Kirchner government made new friends in South America. After the default, the private markets shut Argentina out of the ‘conventional' sovereign debt markets. The government was in desperate need of financing to get out of the crisis so Argentina created peso bonds and sold them to Venezuela, who later sold them on at a profit.

Venezuela did not just buy bonds; it also offered up-front payments to prevent large Argentine companies such as SanCor (a dairy manufacturing cooperative) from economic collapse.
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The Venezuelans receive future exports from SanCor in return. In effect, solidarity funding is being paid off in yogurt futures: a creative and healthy choice. Solidarity credit gave Argentina an alternative debt market; it provided crucial funds that helped the Argentine government get back on its feet financially and allowed it breathing space to correct budgetary problems.

Option Three: The Default Option

The new Irish government should try to avoid a debt spiral by whatever means necessary (conventional or not). Failing this, there is the worst-case scenario: a hard default on Irish sovereign debt. This was the fate of Iceland in 2008 and Argentina in 2002. The effect on the Irish economy of an uncontrolled default would be extreme and unpredictable. Ireland would also risk currency devaluation with the resultant loss in the purchasing power of citizens' savings and in difficulties paying off Euro-denominated debt.

Devaluation happened in both Iceland and Argentina. If it were to happen in Ireland this would imply a break with the Euro, analogous in some ways to Argentina's break with the dollar peg in 2002, but worse, as Ireland has no obvious currency to fall back on. In Argentina's case the peso dropped from $1.00 to $0.30 in days (in September 2011, 1 peso was worth 23 US cents). In Iceland, 75 kroner bought €1 before the crisis; after the crisis €1 cost 180 kroner.
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In Iceland's case the country was able to return to debt markets within three years; not so Argentina. The markets were unwilling to accept peso-denominated bonds, especially after yet another Argentine default in 2002, and due to high internal Argentine inflation.

Some Irish pundits blame everything on the Euro but the Euro was not to blame for Ireland's financial problems. The problems in Ireland are not Euro–punt issues. The Euro is a competitive currency to the US dollar; the punt was always a dependent currency aligned with the British pound. Neither is Ireland's relationship with the Euro analogous to the peso peg to the US dollar in Argentina: for Argentina the dollar is a foreign currency. Membership of the Eurozone is, at least in theory, a more reciprocal relationship. The true extent of this Euro reciprocity still remains to be tested. Reverting to a new Irish punt would make Ireland more prone to speculative attacks against its new currency. It would be hard to convince financial markets of the stability of a defaulted and devalued currency. The resultant devaluation could be severe, making payment of Euro-denominated debt obligations more difficult in a weak new national currency. The state would have to maintain high foreign currency reserves to stabilise the value of the new punt. A break with the Euro is far from optimal, but it is possible. If it proves necessary it may be the least-worse scenario.

The Moral of Argentine Sovereignty

The fair distribution of the cost of debt restructuring gives governments a chance to recover by spreading the pain more equitably through society. Investor rights are important but so are human rights, as is national sovereignty. New human rights litigation was begun by former President Nestor Kirchner in 2003 and continues to this day under the presidency of his widow, Cristina Fernandez de Kirchner (re-elected in October 2011). Most trials are for crimes during the last dictatorship but these are not unrelated to Argentina's sovereign debt. During Argentina's latest dictatorship, between 1976 and 1983, sovereign debt rose from $7.8 billion to $46 billion. Some calculations put this increase at about 20 per cent of Argentina's current sovereign debt obligations.

One of the most questionable economic measures was a law pushed though in the latter years of the dictatorship that effectively cancelled the foreign debt of much of the private sector. This has analogies in Ireland but the scale of the rescue of the Irish private financial sector is responsible for much more than 20 per cent of Ireland's nominal sovereign debt. A government-sponsored audit, like that which took place in Ecuador, has yet to happen in Argentina, but an extraordinary investigation was begun by an individual, Alexander Olmos, after Argentina's return to democracy in 1983. Olmos was so incensed by fraud during the dictatorship that he spent much of the last two decades of his life active in this prosecution.

In 1990 Olmos wrote an analysis of the fraud in his book,
The Sovereign Debt: All that You should Know but which They Kept from You
. The Olmos litigation
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ended on 13 July 2000, just months after Alexander Olmos's premature death. It resulted in 470 commercial and financial proven irregularities. Criminal and correctional judge Dr Jorge Ballestero released his conclusive findings:

Companies of significant importance and private banks with international debt, by socialising costs, even now compromise public finances servicing the sovereign debt …. The existence of an explicit relationship between the sovereign debt … and the sacrifice of the national budgets since 1976 cannot have gone beyond the notice of the IMF who supervised international negotiations.
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The
de facto
government collapsed shortly after losing the Malvinas/Falklands war in 1982. Taking private debt public was a naked transfer of wealth from future Argentine taxpayers to influential private firms. Later studies indicated that this had negligible stimulus effects. The studies also showed that firms with the closest political contacts to the dictatorship received higher rates of debt alleviation. Much of the debt that companies claimed to have on their books (for which they received public guarantees) never even existed.

Redacted documents used by the Dáil committee investigating the bank rescue show that since early 2008 the Irish government had been debating how to rescue its financial sector. It received considerable advice from PriceWaterhouseCoopers, Merrill Lynch, Goldman Sachs and Morgan Stanley, and from the British government (which had the recent experience of nationalising the British bank Northern Rock).

On 19 July 2011, the
Financial Times
Alphaville blog published a story entitled ‘Inside Ireland's Secret Liquidity' by Joseph Cotterill, which cited the same redacted documents used by the Dáil committee. Cotterill's examinations make Brian Lenihan's blanket rescue of the banking sector look even more like a rogue event, demonstrating that it flew in the face of direct advice from the secret overview of a financial stability resolution dated 8 Feb 2008, from the Irish Department of Finance. That advice included the following statement: