FinanceAndEconomics

The severe economic restrictions imposed on Ireland by the euro members and the IMF have predictably led to a political crisis. This is a dangerous development, but not unexpected; but how dangerous may not be generally understood. The principal issue is the banking system, which must be saved at all costs, if a run on the whole of the European banking system is to be averted.

The decision has been taken at Euroland level to prevent the Irish banks going to the wall, because of the high level of counterparty risk and because their financial condition is a reflection of the whole European banking system. The Irish banks are a considerable link in the European banking chain, with a combined balance sheet of €1,239bn, which is over eight times larger than Ireland’s GDP. It is therefore not realistic to expect the Irish to support their banks because it is simply too great a task. That is why Ireland’s government collapsed last weekend, as it dawned on the political classes that the Finance Bill agreeing to the Euroland and IMF loan terms was simply a suicide note.

Euroland’s error was nailing the Irish economy down so hard the Irish voters were bound to rebel. There is cross-party agreement the Finance Bill incorporating the bail-out terms will be passed in the coming days, come what may. This expectation denies the very reason for the Government’s fall, and if the Finance Bill is forced through, the door will be opened for the likes of Gerry Adams to pursue a campaign with public support to reverse it.

The Irish banking system has capital and reserves of €90bn, giving a fractional reserve ratio of 13.75 times. This is a very generous assumption (for the banks), since the definition of capital and reserves includes depreciation, and there are collateral losses not yet accounted for, which would probably more than eliminate this capital. The Irish banks are beyond insolvency, and are collectively bankrupt.

It is not generally appreciated that this problem is the downside to fractional reserve banking, yet on reflection this is obvious. When depositors withdraw funds and a bank is unable to replace them, the difference has to be met out of the bank’s own capital. For instance, Allied Irish shows core capital of about 6%, so it takes very little to tip it into bankruptcy. For this reason the ECB has been quietly working to shore up the Irish banks, by lending them money, taking their debt as collateral, and by allowing the Central Bank of Ireland itself to inject money into the banking system to cover loan interest. The ECB working with the Central Bank of Ireland, having presided over a credit bubble of extraordinary proportions, is now trying to stop it deflating.

In lesser crises central banks have in the past successfully bailed out the banking system, but for a major crisis like today’s the precedents are not encouraging. Throughout the history of banking, from ancient Greece to today, there have been times when banks have leant out money they do not themselves possess. Indeed, this is so ingrained in modern banking that we think fractional reserve banking is normal banking practice. It is not: it violates a natural law of contract, from which only banks are exempt: they act as custodian for other peoples’ money and at the same time uses it as if it is their own. And this is the crucial point: every time banks have created credit by lending money they do not themselves possess, it has eventually resulted in banks going bankrupt. [i]

It is to deal with this inevitability that central banks were created, their primary function being to rescue banks that have descended from the habitual insolvency of credit creation into bankruptcy. They do this in two ways, by rescuing individual banks when not to do so threatens to bring down the system, and by printing money to soften the contraction of bank-created credit. These are the primary tasks faced by the ECB, and not as the ECB’s own rhetoric states, the control of inflation.

If the starting point in this crisis was a better position, its realisation might be deferred for another credit-driven economic cycle. In other words, a further expansion of credit might be engineered that would get some sort of economic recovery underway; a recovery that would underwrite cash-flows, employment and taxes. But this is not the case in Euroland, which is split into three rough categories: the German economic area, which is showing signs of economic recovery, a number of jurisdictions which could tip either way, and the PIIGS, who over-burdened with debt are sinking further into depression.

Taken as a whole, the prospects for a European economic recovery are poor, so any short-term action by the ECB is not underwritten by improving prospects. A poor economic outlook and the high levels of consumer and government indebtedness in most Euroland countries also limit the prospects of renewed credit creation by the banks. Instead, there are a number of combining factors that are leading to an accelerating contraction of bank credit, and this is particularly reflected in debt markets. Debt is being turned into cash rather than extended, and the cash is being provided by the ECB. The ECB has the burden of refinancing the loan obligations for both the public and private sectors that private sector banks are unable or unwilling to refinance themselves. If the ECB does not do this those private sector banks will go under.

The enormity of this task means the ECB can only defer a banking collapse for a limited time. The Irish problem, which has been handled insensitively, is both a wake-up call to the complacent, and an escalation of the problems faced by the ECB.

[i] The illegality of banks lending their customers money without full cover was recognised in Roman law. Its modern legal acceptance dates from Peel’s Bank Charter Act of 1844. For a detailed debate on this issue, see Money, Bank Credit and Economic Cycles, by Jesus Huerta de Soto.