A Way Out for Ireland

Irish economist Morgan Kelly recently published in The Irish Times a short history of the European Central Bank’s bailout of Ireland’s banks. The short version of Kelly’s thoughts on the subject is that Ireland got a bad deal, but there’s a way to get out of it.

Kelly points out that the Irish government’s guarantee for the loans made by the country’s banks should have been revoked as soon as it became clear that the debt was too large to handle. At the time the country’s central bank reckoned that the banks’ losses were containable, believing that the country’s economy was still driven by exports, and not, as Kelly points out, a “credit-fuelled Ponzi scheme” based on the assumption that real estate prices could only rise. Sound familiar?

The government paid out some €60 billion to the banks’ bondholders, and soon discovered that it could no longer borrow on the credit markets. That should have been no surprise, because the loans the government was holding were the problem in the first place.

When the ECB offered a bank bailout in November, the government first declined, as Kelly puts it, on the grounds “Ireland could hold happily its breath for long enough that Spain and Portugal, who needed to borrow every month, would drown.”

But when the IMF proposed a financing plan that would have given Irish creditors a haircut, US Treasury Secretary Timothy Geithner rejected the plan. Left with no alternative but the ECB’s austerity-based plan to make Irish taxpayers pay off the creditors (of which Germany and France are two), the Irish government took the ECB’s bailout.

Kelly says that the Irish are being made an example of, for the benefit of Spain. The ECB wanted the Spanish to see what could happen if the country couldn’t get its fiscal house in order.

In Kelly’s opinion, Ireland is destined for insolvency. It’s total debt will soon be in the range of €220-€250 billion, about 1.6 times GDP. Even having Ireland default on its bonds doesn’t help much because most of the paper is held by Irish banks and insurance companies. The debt could be wiped out, but the country’s entire economy would be bust.

Kelly’s prescription: “National survival requires that Ireland walk away from the bailout. This in turn requires the Government to do two things: disengage from the banks, and bring its budget into balance immediately.”

The ECB does not want to rescue Ireland’s banks, but it doesn’t want them to fail either. After all, €160 billion, the amount the ECB has lent to the banks, is real money. The ECB is stuck –  Ireland can just walk away from the debt by returning very shaky assets to the banks and retrieving the government’s promissory notes. This is not the lesson the ECB wants to send to Spain or Greece or Portugal.

The second thing the government must do is to stop borrowing altogether. That will hurt, of course, but not as much as having to pay a never-ending bill to the ECB. As Kelly says, “By bringing our budget immediately into balance, we focus attention on the fact that Ireland’s problems stem almost entirely from the activities of six privately owned banks, while freeing ourselves to walk away from these poisonous institutions.”

Ireland threatened to do much the same thing months ago, but pulled back. Exactly this same thinking applies to Greece and Portugal, and the ECB knows it. The debt crisis in Europe is a banking crisis, especially in Spain, Ireland, and Portugal, and the ECB does not have the tools to deal with this. The threat to the euro is real, and the only weapon the ECB has at its disposal just seems to make things worse.

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