Ireland: is there a way forward?

Professor Morgan Kelly (picture University College Dublin)

By Patrick Mc Nally

It is now some months since we have had a change of government. Already the old regime has faded into the mists of history. The voters have decided and punished the outgoing government for their mismanagement of the economy and are willing to give the new government the benefit of the doubt for the time being

There are two narratives running side by side in relation to the euro crisis and they are contradictory. The eurozone analysis asserts that the crisis in the eurozone has been contained. The financial market analysis is more brutal, more stark and clear that the crisis is far from contained

The eurozone analysis is that the problems of peripheral countries are a debt crisis due to their reckless borrowing. The solution is an austerity programme to reduce overspending and to repay the bond holders who have loaned the money. It is summed up in the mantra “Ireland borrowed the money, Ireland must repay the money”. This is like saying in the UK context that the Royal Bank of Scotland is a Scottish bank with headquarters in Edinburgh: “Scotland borrowed recklessly and Scotland must repay the money”. This highlights the essential difference between the UK and the eurozone, namely the lack of political union in the eurozone.

The financial market analysis is that the European Central Bank will continue to drip feed the Irish banks. This funding is then being transferred into Irish government sovereign debt. Meanwhile the European Central Bank loans are being used to repay the French and German banks’ secured and unsecured bondholders,

This process of increasing government sovereign debt is fuelling market unease about the country’s ability to repay the debt. This heavy level of debt means that Ireland must have economic growth if it is to break out of the debt trap and this won’t happen if Ireland continues along the path of fiscal austerity. There have been suggestions that the Government should consider the option of reducing the corporation tax rate from 12.5 per cent to 10 per cent or even to 7.5 per cent in order to stimulate inward investment and job creation.

The financial market predicts that Ireland will run out of money by 2012 or 2013 Any further government borrowings will require higher interest rates because of the fear of default, assuming that there are countries willing to lend to Ireland can be found. It is further suspected that additional cuts will be required in public sector pay and social welfare payments if such loans are made available. This will prove unacceptable to the Labour part of the coalition government. The government will then fall and there will be an opportunity for a new or existing party to adopt or rebrand itself by adopting a more marked eurosceptic tone. Sinn Féin is now calling itself a eurocritical party. Ireland is caught in an austerity mandated budget by its European partners. Irish workers and citizens are to bear the burden of mistakes that were made by European banks in terms of higher unemployment, lower wages, higher taxes and cutbacks in public services. It is a massive and unjustified and unjustifiable redistribution of resources from Ireland to the core countries.

It is clear that single currency is a success. Urged on by politicians, bankers have treated the eurozone as a single market. In a sense it is no longer sensible to classify the loans as Greek loans, Irish loans or Portuguese loans. The billions of euros borrowed by the periphery countries have been sourced from banks in the core countries and these loans were very profitable at the time. So now that the periphery countries can’t repay the loans the core countries have a problem. That is economic integration. The argument boils down to the question of who pays: reckless borrowers or reckless lenders or a combination of both. The crux of the argument is whether senior bondholders should share part of the burden because of their foolish investment decisions.

The G7, Ecofin and the ECB all ruled out burning the bondholders leaving Ireland isolated. They feared that a default would spread contagion across the rest of the eurozone. The US support for this position at the G7 caused some surprise. The reason for the US intervention is that they were concerned about the impact of default on US banks that have insured the holders of Irish bonds against default through complex financial instruments known as credit default swaps.

It is calculated that net losses faced by international banks that have insured with US companies against Irish bank bonds and Irish debt would amount to €6 billion in the event of default, a figure easily containable within the US financial system.

However when you calculate the net exposure of the international banking sector to credit default swaps written on European banks the figure jumps to €108 billion.  On top of that the exposure to all Europe’s sovereign debt is €120 billion. Thus an Irish default would have a dramatic and unwelcome impact on US banks. A financial tool that was meant to disperse and minimise risk has simply spread it like an invisible virus through the banking system.

There has been no significant change in the views of the European Central Bank that there must be no haircuts for bond holders. This in effect transfers the burden of the losses from the banks to taxpayers. This means that core countries’ taxpayers are lending funds to the periphery countries, while the periphery countries’ taxpayers are repaying core countries with these bank loans and paying high interest rates on the loans.

Today the bondholders have been largely repaid. German and French banks now hold only €10 billion of Irish sovereign debt but they hold €74.5 billion of Irish bank debt.  €70 billion has been made available by the European Central Bank to Irish banks to repay senior bondholders over the past two and a half years. No wonder the European Central Bank is keen to prevent Ireland defaulting on bank debt. A default would expose the losses within continental banks especially the German Landesbanken. In effect Ireland is paying premium prices for junk bonds and this represents a massive transfer of resources from the Irish taxpayer to continental banks.

It is estimated that Ireland currently owes €86 billion in public and private debt to Germany. Bank for International Settlements figures show that European banks had a total exposure to Ireland of more than €400 billion at the end of September 2010. The market thinks that eurozone financial authorities believe that the Irish contagion will have been ring-fenced by the end of 2012. At this point Ireland will be effectively thrown to the economic wolves and Irish government default on sovereign debt will be seen as a sensible solution to the problem..

For Ireland the bailout has not been a success. It is unlikely that Ireland will be able to return to the international market to raise funding for many years. In a recent Bloomberg News interview, Mohaned E;-Eriab Chief Executive of PIMCO bond fund managers (with investments of $1.2 trillion) said that he was shocked that taxpayers were bearing the brunt of the banking collapse. He said that the Irish government’s policy of paying back creditors in a debt crisis has not worked in the past and will not work this time. The creditors so far have not taken part in any burden sharing. It is remarkable, it is inadvisable, but it has been a political decision.

The European Banking Authority will apply stricter capital rules in its next round of bank stress tests; however it has yet to agree on an exact “pass mark”. The proposed new bank stress tests to be published in June are tougher then the previous tests with more pessimistic projections of gross domestic product growth and property market prices. Investors have already dismissed the exercise as a publicity stunt that will shy away from revealing the type of problems unearthed in Ireland. The recent independent Irish bank stress tests were stringent and conducted by Blackrock and they included individual housing mortgages. The benchmark used was the US state of Nevada where Standard and Poor’s rating agency estimated that house prices have fallen 58% from their April 2006 peak. Critics also argue that the European stress test focus is too narrow, looking at sovereign debt and not at sovereign debt default. The markets believe that the tests will be pitched at such a level as to conceal French and German bank losses. If the real losses were revealed, it would require large capital injections by French and German taxpayers. What is happening in Ireland is extraordinary said a senior executive at a European bank in regard to the recent independent bank stress tests. The only good thing is that the Irish are determined to bring their problems out into the open, which is not true for most of the rest of Europe. If you were to apply the Irish stress test across the rest of the eurozone the number you would come up with for the subsequent capital shortfall would be alarming.

The choice facing core country politicians is to fund their banks or to fund the peripheral countries. Political weakness and confusion more than deficits are at the core of the eurozone’s fiscal difficulties. The secret of the eurozone finance is that if one of the periphery countries were to default, German banks and in particular the state owned Landesbanken would be amongst the biggest losers. It therefore makes sense for core countries to bail out the periphery countries as they are all in this banking crisis together. The reason for the slow reaction by European leaders to the crisis and the short-termism of the eurozone’s responses are the French presidential election due in 2012 and the German parliamentary elections due in 2013.

There are many proposed solutions to Ireland’s difficulties ranging from leaving the eurozone, staying with the current rescue programme, and the Morgan Kelly solution of walking away from the programme.

In regard to leaving the eurozone, it is believed here that the recent “secret” meeting in Luxembourg, combined with Der Spiegel’s online report that Greece was proposing to leave the euro that weekend, was this tactic in operation. The Greek government played hardball with Germany and said that in effect if Greece did not get debt relief it would resort to the nuclear option of walking away from the euro. Greece would introduce a new drachma at the value of one euro, turning euro debts into new drachma debts. The new currency would be allowed to float at some point. If floated it could be anticipated that the new currency would drop 70 per cent against the euro, thus leaving a big hole in core bank finances but reducing Greek indebtedness and allowing the country to recover from its financial crisis. Lawyers would be left to sort out the outstanding debt issues as to who gets what and when. Ireland, it is argued, should play hardball and adopt the same tactics: threaten to leave the euro and argue for a restructuring of the massive debt on more favourable terms.

Those who argue that Ireland should stay with the existing programme recognise that it will produce slower growth and will mean that Ireland will be unable to return to the market as scheduled with default probably unavoidable if economic growth cannot be achieved.

Then there is the Morgan Kelly proposal of walking away from the deal altogether. His analysis is broadly accepted, it is the solution he proposes that is controversial. While presenting a good case for default and a swift balancing of the national budget, the implications mean that it would be difficult to obtain foreign loans and his proposal is linked to a policy of bringing government expenditure and income into line within a year by cutting the budget by €18 billion in a year compared with the current proposals of reducing the deficit by €6 billion a year.

His belief that €18 billion of government deficit can immediately be reduced is not possible or socially desirable. He recognises that it would mean a 30 per cent cut in government expenditure, equivalent to 10 or 12 per cent of GDP.  It would mean big cuts in pay levels and pensions, increases in taxes and cuts in public capital expenditure. Morgan’s budget plan deepens the recession and hurts everybody. The collapse in demand and employment would be immense. The proposal is regarded as a lethal injection into the economy and the likely consequences would be unacceptable to the public at large. As Ireland is one of the economies most dependent on international business, Ireland simply cannot walk away.

A number of commentators argue that Ireland is being financially bullied by our European partners who are profiteering to the tune of €1.3 billion a year from the draconian interest rate on the loan. The coalition came to power promising that they could renegotiate a revised plan, but the EU is unlikely to tolerate this. The general public is now becoming aware of the new reality and is not as yet prepared as it needs to be should the situation take a turn for the worse. There is now the possibility of a backlash given that the election was fought on a false premise that a change in the terms of the bailout could be obtained. A reduction in the existing rate of interest on the loan is proving difficult: much will depend on how the crisis develops.

The market has no confidence in the EU’s efforts to avert a full blown debt crisis. Europe’s finance ministers need to acquire market credibility. The EU funding mechanism will buy more time but debt restructuring is inevitable giving rising debt. Plans for an orderly process for eurozone sovereign default are already threatening a total shutdown of the peripheral countries’ return to the bond markets. The longer the EU, the ECB and the IMF persist with implementing their current plan, and when it becomes clear that it is not working, the more likely it becomes the eurozone will find that it is grappling with the consequences of a potential Irish sovereign default.

The EU is facing a creeping death. The time has now come to make a final push for European integration. It is slowly being recognised that the only way to save the euro is to move towards political union. It is an increasingly inescapable conclusion that monetary union cannot survive unless it becomes the currency of a fiscal union which by definition would have to be more of a political union. This immediately reopens the original critical questions of who should join the euro; becoming a question of who should be a member of the proposed monetary and fiscal union.

Fiscal union probably means ceding control to a central, probably German-dominated authority. The choice for Irish voters if they are faced with this choice would be security and stability within a union in which Ireland would only have a marginal say in economic policy, or uncertainty and probably financial hardship outside such a union. It is a choice that most Irish voters would not relish. That does not mean that the question won’t arise in Ireland as well as in Europe. Unpleasant political choices can only be delayed for so long and the debate has not yet even begun here in Ireland. The fear is that current European leaders are not able to articulate this solution. The us against them national approach to the crisis is encouraging rising nationalism within individual European countries, sapping public goodwill for Europe as a whole.

The politics of the bailout is beginning to work its way into public consciousness. The way the recent bailout was arranged has raised a number of questions. It appears that the ECB threatened that if Ireland pursued the question of burden sharing then it would cut off funding. The ECB’s behaviour has created resentment especially in regard to what is seen as a penal rate of interest on the loans which are proving to be highly profitable to those advancing the loans to Ireland. It appears that a policy is being dictated to an elected government by a remote and unaccountable financial authority and to compound the problem the policy is not self-evidently a good one. There is no visible end or exit strategy which would encourage hope that there is a solution to the current financial crisis. Much of the tabloid coverage in regard to the rescue is anti-European in sentiment.

European leaders are years into the battle to save the euro. The battle is not yet won. It is exhausting and the longer it goes on the more difficult it is to keep going. The only good news is that as the eurozone crisis lumbers on, it is lumbering in the right direction. Europe‘s squabbling leaders pursuing national interests over those of the whole eurozone have failed to take the drastic action many thought necessary to halt the chaos. All the measures taken to date at European level and at national level have done enough for now to contain the crisis.

It is also believed that there has been a shift in the balance of power within the EU’s institutions. The ECB has now emerged as the most powerful European institution, feeling strong enough not to inform the Commission beforehand of the Irish bailout. Here is a powerful unelected institution, with only notional accountability to the European Parliament, redefining Europe.

Another concern is the future of German policy in Europe. In a recent speech to the College of Europe in Bruges, Angela Merkel seemed to promote intergovernmental institutions over Community institutions, thus downgrading the Community approach which has been essential to European integration and forms the basis of equality on which countries cooperate with each other.

The holding of a secret meeting involving the big EU states, the European Commission and the ECB in Luxembourg recently without informing smaller countries has further fuelled concerns. Such meetings raise serious questions as to who is running the Union.

The bailouts of Greece, Ireland and Portugal were necessary but they are not sufficient to address these countries’ problems which differ in each case. Greece’s collapse was due to long term fiscal irresponsibility, while Ireland’s was a classic housing bubble followed by a systemic failure of the banking system. Ireland argues that a bailout policy of one size fits all is inappropriate and that distinct solutions are needed for each state.

Further bailouts by the core countries of the periphery countries will cause resentment amongst their taxpayers. There are two problems for the eurozone that need to be resolved. Can a bank be allowed to fail, and can a country restructure its debt without causing huge damage to the financial system? The issue for Europe’s leaders is to decide whether their citizens would be more willing to pay to restructure their own banks or to support the peripheral countries in their efforts to shore up core economy banks.

It is now clear what a comprehensive solution to the eurozone problems will involve. The common financial strength of the Union’s core will have to be harnessed to stand behind the debt of the periphery countries, perhaps involving significant restructuring of debt, in return for a much more centralised and controlled model of economic governance. This will reduce significantly the financial and policy freedoms of national governments, and will see a substantial pooling of sovereignty. The problem is that by the time members are ready to sign or opt out of such an arrangement, events will have run ahead of the politics. One of the characteristics of the euro crisis is that politics have been consistently behind the financial crisis. For politics to get ahead of events is going to require a quantum jump from Europe’s political leaders, which recent European Council meetings show is a remote prospect.

The Lisbon Treaty has failed in its promise to bring Europe closer to its peoples. For good or ill, national politics are becoming more Europeanised. Many who fought for a Yes vote for the Lisbon Treaty here in Ireland feel let down by the attempts to force a reduction in the current level of Ireland’s corporation tax. It is still remembered that President Sarkozy came to Ireland during the second Lisbon Treaty referendum to reassure Ireland that it would always have control over corporation tax rates. The Franco-German insistence on a cut in this tax risks turning Ireland into a eurosceptic country. If this happens it is likely that any future EU treaty reform will be rejected by Irish voters regardless of its merits and regardless of how many times the referendums are held. There is clearly no recognition by France and Germany that the Irish banking guarantee has shored up German subsidiary banks operating in Ireland, such as Hypo Real Estate and its Depfa subsidiary which could otherwise have cost Germany up to €120 billion. It is estimated that the Sachsen Bank misadventures cost it and other Landesbanken €17 billion, yet a recent report states that Deutsche Bank is to move its entire European hedge fund administration operation to Ireland.

After three years of crisis it is now becoming clear that we now need a pan-European debate to find a common path to the future. Ireland is more deeply entangled with its partners in the European Union as a result of the banking crisis and the measures taken by the government to resolve it. We are now seeing the Europeanisation of domestic politics. Political actors from other EU member states now participate more in Irish political debates, recognised as legitimate participants in discussions about common European problems.

Irish ministerial participation in European Council meetings is now taking place on a more regular basis in an attempt to recreate the informal networking at which Ireland had been so good at in the past. Irish candidates are being encouraged to seek employment in European institutions. It is argued that If Ireland is to make demands on the system then it is essential that there is an adequate voice within that system. This is seen as a current serious weakness. A more Europeanised politics is struggling to emerge from the eurozone crisis in Ireland as in other EU member states.

The process is still uneven and fragmented, weakly organised and dominated by existing public and private power holders. It is buffered by right wing eurosceptics who say little can be achieved at the transnational level and that national sovereignty needs reinforcing to solve national problems if their populations are to be protected. The European left argues that existing European structures are legally loaded against those who want to change the political and economic system. Outside these groupings are the relative winners in the existing system of integration.

The richer and more mobile middle and upper middle classes who travel more, and speak second languages are the gainers and have become members of new transnational networks and have learned generally how to turn these benefits to their advantages. The losers tend to be the poorest and least educated and the oldest citizens who have travelled less. Then there is the vast majority of citizens who see and experience many benefits from European integration but insist that the free education, health care and fixed pension benefits they enjoy at national level should be maintained. This majority group’s interests need to be served by further integration as they are more likely to assert them more effectively at EU level if they are given an effective voice.

If European leaders continue to hijack the EU project as a populist platform to electioneer in their own countries it will almost certain that the European idea will die in the imagination of the European citizen .The new emerging politics is now not between left and right but between those who have gained by globalisation and open borders and those who have lost and have been let down by European and national authorities.

The far left has repackaged itself by calling for social justice in an age of globalisation.  Populists are appealing to disaffected working class and lower middle class voters for whom globalisation and European integration have brought few apparent benefits but have exposed them through immigration to greater competition for jobs and public services at a time of economic insecurity.

The modern far right meanwhile offers orientation for those lost in modern society. The new populist parties are now appealing to the middle classes who are afraid of losing their standing in society if they have to keep paying for others. They are also able to mobilise responses to grievances over immigration issues better than the major parties.

The weakness of the pro-European political movement is the technocratic nature of much that happens in Brussels. This means that many voters feel they have little political effect on EU decision-making.

The European political establishment should not underestimate voter frustrations at the current EU crisis nor the determination of the new populists to play a double game to fan the frustrations and profit from the aggravated crisis. They thrive in complex but vital areas of policy where voters feel left in the dark by national parliaments and EU institutions. Populism can be useful if it puts topics on the agenda which the mainstream parties have ignored. Europe’s political parties need to defend their decisions and explain more the benefits of EU and euro membership, especially in times of crisis.

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