Here come the Argentine Style Riots in Ireland

Sorry, the post title is over the top. Actually, let’s hope there are no riots. There is certainly anger on display in the Guardian video clip below.  So far these are pretty tame protests.

Here are the things I see as problematic:

• the Irish corporate tax regime. Many in the EU want to get Irish taxes up and will use the EFSF as a Trojan horse for doing so.
• the Irish are worried about their institutions falling into foreign hands. Foreigners taking over is what one has seen in weak banking systems in E. Europe and Latin America.

The Financial Times is making it seem that in fact this is exactly what is occurring. It reports a showdown between the EU and IMF officials on the one side and Irish officials on the other regarding the low 12.5% Irish corporate tax rate. The Irish officials see the tax policy as integral to its industrial policy and a major attraction of foreign companies along with its English-speaking, well-educated and youthful labour force. Raising corporate taxes will make Ireland less competitive and make reaching austerity budget cut targets that much more difficult.  But, it seems that is what is being requested.

However, the question is whether the Irish are truly in a position to dictate terms. To date, the government have contended they don’t need a bailout and have not requested one. The EU is trying to foist it upon Ireland to prevent contagion, so the story goes.  But widespread reports of institutional depositors pulling funds out of Irish banks is weakening the banks to the point where it could deplete government funds.

Comically, the Spanish and Portuguese are playing the same transparent game. One Portuguese official made a pointed contrast to the troubles in Ireland, saying Portugal had not suffered a housing bubble and that its banking system was "resilient, solid and well-capitalised."

So what’s next?

I believe the Irish central bank head Honahan has it right when he says  a deal "is definitely likely to happen." The question is on what terms. Reports are for 80-100 billion euros to go straight to recapitalising the banks and not to the sovereign.  In hindsight, the bank debt guarantee is the real sticking point for Ireland at the moment. Just to review the problem, Willem Buiter said the following just after the scheme was set up:

Only if punishing the debt holders were to endanger systemic stability would there be a reason for making the holders of the debt whole.  Clearly, the debt does not create any problems until it matures.  Since the Irish banks have to shrink their balance sheets quite significantly, problems with rolling over maturing debt should be manageable; at worst, it might require government guarantees on new debt issued to replace maturing debt (if debt matures at as rate faster than the desired rate of contraction of the Irish banks’ balance sheet).

Instead of having to fund a limited expansion of deposit insurance for its banks, which would have been enough to prevent bank runs, the Irish tax payer has socialised all the funding risk of the banks, except for the equity.  There is no upside for the tax payer in this arrangement.  The state gets no equity or warrants out of this scheme.  It is a straight transfer from the Irish tax payer and the competitors of the Irish banking system, to the shareholders and other creditors of the Irish banks.  They have now been rewarded for incompetence and recklessness.  The example of the Irish Nationwide Building Society shows us how this inept bail-out will affect the Irish banks’ incentives for future reckless lending.  I hope the Irish tax payers have deep pockets.

–The Irish solution: unlawful, beggar-thy-neighbour and short sighted, but apart from that OK

That’s probably right. But, like P O O’Neil, I would like to know what the European Finance Ministers were telling Brian Lenihan when he made the guarantee (because many made deposit guarantees subsequently too). Now they are acting like this was the most reckless thing in the world.

Today in the lower house of the Irish parliament, Minister for Finance Brian Lenihan repeated a statement that he made on Irish radio yesterday concerning European endorsement of the Irish government’s policies in relation to the banking crisis.  Specifically, he told the house(around 9 minute mark)

The fact is that every finance minister in Europe [Eurozone] indicated that the [blanket bank liability] guarantee was the correct policy at the time [September 2008].

The basis is this paragraph from the Eurogroup statement following their Monday meeting

We welcome the measures taken to date by Ireland to deal with issues in its banking sector, via guarantees, recapitalisation and asset segregation. These measures have helped to support the Irish banking sector at a time of great dislocation. However, market conditions have not normalised and pressures remain, giving rise to concerns that further reforms and stabilisation measures may be appropriate.

And remember, the Swedes did pretty much the exact same thing as the Irish when they rescued their banks.

In September 1992 the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden’s parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible.

The bank guarantee provided protection from losses for all creditors except shareholders. The Government’s mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard.

Read more: https://www.creditwritedowns.com/2008/08/swedish-banking-crisis-response-model.html#ixzz15fV0ROZK

As I see it, the major differences between Sweden and Ireland were twofold. One, the Swedes had their own currency. They could effectively print money to recapitalise the banks if necessary. Ireland doesn’t have national monetary sovereignty because of the euro so that option is out.  The analogous remedy would be the ECB committing to buy up as much Irish debt as necessary to resolve any liquidity problems – something that will never happen. (Remember, as in the QE2 exercise in the US, you have to commit to a price/interest rate with an unspecified quantity of liquidity to be successful. Specifying a specific amount of liquidity will not adequately adjust price/interest rates.)

Second, Sweden’s banks were smaller relative to the size of Swedish GDP because they had yet to become as internationally  active in the late 1980s and early 1990s. Globalisation wasn’t the hit quite yet. For example, you could see Bank of Ireland deals all over the high streets or in What Mortgage-type magazines in Britain this past decade. And as I recall it, the only Swedish bank with any real presence in New York at the time of the Swedish crisis was Handelsbanken (correct me if I am wrong here). And of course that meant their liabilities could be covered in krona for which the government could issue debt that the Riksbank could buy up in extremis.

For Ireland, the original bank guarantee scheme expired on 28 September 2010 according to the Irish National Management Agency. Ireland re-upped and the guarantees will expire in June of 2011.

Just to repeat:

What are the realistic scenarios here then?

1. The Irish get funds from the EFSF and the IMF now rather than waiting. They push ahead with austerity and rescind the bank creditor guarantees while protecting depositor guarantees.  In my view, this would satisfy the EU’s desire for fiscal consolidation while making the bank backstop credible. Depositors would know their money is safe.
2. The ECB buys up a bunch of Irish sovereign debt to bring yields down while the Irish government denies it needs the money. They push ahead with austerity, which is voted for on Dec 7. I don’t like this scenario. The sovereign gets the ECB backstop. But rates will not come down.  The Irish will still be forced into the EFSF and the arms of the IMF anyway and the prospect of bank runs could continue. Deadweight losses are likely. This is a failed strategy.

My understanding is that plans are now to use bailout money to shore up bank capital in Ireland. This is not a good idea at all – and I don’t think the Irish public would support this.  Bank creditors need to be cut loose to de-couple the bank and sovereign credit issues.

–On The Alleged Irish Bank Deposit Flight

The Irish are going ahead with the recapitalisation plans. So that is done. But I would strongly suggest that the sovereign let the bank guarantee scheme lapse in June.

There is the tax issue, of course. But I think the Irish might be able to beat this back.  In the end, trying to flog off one of the banks to a foreign competitor might be the way to go once the liquidity crisis dies down.

I think Ireland is solvent once it jettisons its bank debt guarantee. Bob McKee, chief economist at Independent Strategy agrees, going so far as to recommend buying Irish debt. See the clip below from CNBC and comments from Independent Strategy here.

For the Irish people, the question still remains as to whether the full burden is being heaped on them via bailouts to be repaid and austerity to endure while bank creditors get off scot-free.  So no Argentine-style riots are here yet, but the government needs to cut a fair deal if it is to avoid them as more austerity takes hold.

Update: 22 Nov 2010: It seems the riots have arrived. Video clip below (hat tip Business Insider)