Alasdair Macleod – 28 November 2010
They must be keeping their fingers firmly crossed in Brussels, even praying that the Irish rescue package will do more, much more than buy a little breathing space. Relying on divine intervention will not be good enough, because there are three separate problems that will now make the financial collapse of the euro area a racing certainty. These problems are the large amounts of cross-border lending, misguided economic responses, and creditor-debtor politics.
The scale of the Irish financial threat is considerably greater than commonly realised and presented, because the relative size of the Irish economy is being confused with the size of its external banking obligations which are significantly larger than those of Spain or Italy. Cross-border loans to Ireland by BIS-reporting banks amount to the equivalent of $715bn, and the comparable figures for Spain are $534bn and for Italy $467bn.[i] Of course these are not the only cross-border financial flows, because they do not include outward banking deposits and securitised debt issued by the Irish government and large companies. But they are the figures that matter.
So we must focus on the banks, because they are at the heart of the real crisis. The cross-border loans by BIS-reporting banks for all the PIIGS amounts to $1,982bn at mid-year, which is 32% of the euro area total and disproportionate relative to the size of the economies involved. So if the largest of these debtors, which is Ireland, is allowed to fail there would probably be a full-blown banking crisis even before markets turn their attention to either Spain or Italy.
These same statistics show that between September 2008 and June this year the PIIGS between them have also suffered loan withdrawals of $611bn, which indicates how hard their economies are being squeezed by the withdrawal of credit. For Ireland alone the figure is $165bn, about the same as one year’s GDP, and more withdrawals will have taken place since June, putting the proposed rescue package of only $113bn into context. This acute deflation is being conducted at the same time as taxes are being increased, which brings us to the serious mistakes being made in the management of the economy.
The Irish government has got one thing right: the importance of keeping corporation tax low. Brussels views things differently, partly because Germany and France see Ireland as unfair competition with respect to corporate location. So between Brussels and Dublin an ugly camel is born, and their attempts to close the budget deficit by a mixture of tax rises and public sector wage cuts while robbing state pension funds betrays a lack of resolve to tackle banking solvency properly. It is madness to punish the Irish people for the current banking crisis, because Brussels is shooting at the wrong target: rescuing the European banking system does not require the Irish economy to be driven into the ground, it requires Brussels to recognise it has a full-scale banking problem on its hands.
Both lender and borrower must bear responsibility for such wrong-headedness. It amounts to a protection of jobs in the public sector, while taxes are raised from the private sector and pensions are robbed. Taxing individuals and the private sector to reduce budget deficits prevents vital capital formation and so condemns Ireland’s economy to a prolonged period without recovery. This socially-driven approach is counterproductive, a point which will not be lost on the markets, when they work out that Ireland will be less able to repay its creditors because economic recovery, upon which government finances rely, is effectively cancelled.
So markets are now faced with a bail-out too small to reverse the run on the Irish banks, and by an Irish economy that has no chance of economic recovery in the foreseeable future. A bail-out of $113bn amounts to an injection of only half of the money withdrawn from Ireland by the banks in the last two years. It is simply not enough.
The crisis is not helped by the understandable reluctance of the German people to commit more good money after bad. It was difficult enough for Angela Merkel to come up with the funding for Greece, which was sold to the German electorate as a one-off. Six months later it’s Ireland, presumably then Portugal, then Spain. It is no surprise that she wanted someone else, like senior bondholders to share the pain. But talk of bondholder haircuts merely creates a new bond market crisis to add to the banking crisis and will drive up Irish bond yields even further; and back-peddling on this issue is unlikely to undo the damage.
The importance of Ireland is that is the biggest cross-border banking debtor of all the PIIGS. If the Irish banks are not saved, the European banking system will probably go under, and soon, without waiting for the pressure to mount on Portugal Spain and Italy. The politicians and bureaucrats of Euroland have not demonstrated a sufficient sense of urgency and understanding of the true crisis to resolve it: rather they have made it worse. It is now becoming impossible to see a way out of the euro-banking problem without the ECB giving in on its anti-inflation stance and implementing aggressive quantitative easing. However, the ECB was set up to survive attempts to get it to inflate, so if it backs down from its sound-money stance in the middle of this crisis, the euro itself will suffer a loss of confidence.
It looks like divine intervention is the best hope after all.
[i] These figures are as at the end of June 2010 and are from the Quarterly External Debt Database portal of the World Bank.