By Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley; and formerly Senior Policy Advisor at the International Monetary Fund. Cross posted from VoxEU
Irish interest spreads did not fall and contagion continues. Here one of the world’s leading international economists explains why. Short-sighted, wishful thinking by EU and German leadership designed a package that is not economically feasible in the long run (it would trigger a vicious debt deflation spiral) and it is not politically sustainable in the short run. The Eurozone had better have a Plan B for when the new Irish government rejects the package next year and imposes a haircut on Irish bank bondholders.
The Irish “rescue package” finalised over the weekend is a disaster. You can say one thing for the European Commission, the ECB, and the German government – they never miss an opportunity to make things worse.
It pains me to say this. I’m probably the most pro-euro economist on my side of the Atlantic. Not because I think the Eurozone is the perfect monetary union, but because I have always thought that a Europe of scores of national currencies would be even less stable. I’m also a believer in the grand European project. But given this weekend’s abject failure of EU and German leadership, I am going to have to rethink my position.
A solvency problem postponed is a problem made intractable
The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.
According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.
The inevitable populist backlash
This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.
Do Mr Trichet and Mrs Merkel have a contingency plan for this?
Infeasibility of a wage-cutting exit plan
Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in “internal devaluation” because the traditional option of external devaluation is not available to a country that lacks its own national currency.
But the more successful it is at reducing wages and costs, the heavier will be its inherited debt load.
Public spending then has to be cut even more deeply. Taxes have to rise even higher to service the debt of the government and its wards such as the banks.
This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of “debt deflation” about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.
What should have been done
For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. This would have been particularly easy in the Irish case.
A bright red line could have been drawn between the third of the government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other hand.
The third representing the debts of the Irish banking system could have been restructured.
Bondholders could have been offered 20 cents on the euro, assuming that the Irish banks still have some residual economic value.
If those banks are insolvent, the bondholders could – and should – have been wiped out.
Irish public debt would then have topped out at maybe 100% of GDP. And the Irish programme would have had a hope of working. As it is, the programme will have to be revisited, perhaps as soon as next year. Investors know this, which is why Irish spreads have barely budged.
In fact, this is exactly the policy that the IMF, which at least knows how to add, has been pushing for over the last week. But the Fund was unable to overcome the objections of the Commission, the ECB, and the German government.
Why the mistakes?
One can interpret the intransigence of the German government and its EU allies in two ways.
First, they understand neither economics nor politics. As Tallyrand said of the Bourbons, “They have learned nothing, and they have forgotten nothing.”
Second, policymakers in Germany – and in France and Britain – are scared to death over what Ireland restructuring its bank debt would do to their own banking systems.
If the second interpretation is correct, the appropriate response is not to lend to Ireland – to pile yet more debt on the country’s existing debt – but to properly capitalise the French, German, and British banking systems so that they can withstand the inevitable Irish restructuring.
But European officials are scared to death not just by their banks but by their public who don’t want to hear that public money is required for bank recapitalisation. It’s safer, in their view, to kick the can down the road in the hope that something good will turn up – to rely on “the luck of the Irish.”
As John Maynard Keynes – who knew about matters like reparations – once said, leadership involves “ruthless truth telling.” In Europe today, as recent events make clear, such leadership is in short supply.