This was the question put to the ECB’s Klaus Masuch by one persistent Irish journalist. The answer from Masuch was a complete dodge, a non-answer, because everyone knows that the Irish government has heaped what rightfully should be bondholder burdens onto the Irish taxpayer.
The video below is wonderful in getting at the heart of everyone’s problems with the bailouts in Ireland and elsewhere in Europe and the U.S. Take a look below, but let me say a few words first because my thinking here is a bit more complex than "bailouts are bad, default is good".
Here’s what I am hearing:
The answer from officialdom is that the (Irish) banking system was on the verge of collapse and so these debtholders, European banks, had to be bailed out. This is the same answer that Tim Geithner gives in the U.S. as I recounted last March. Geithner calls this "deeply unpopular, deeply hard to understand". And I think he’s right. These measures ARE deeply unpopular, deeply hard to understand. I don’t support the bailouts of bankrupt institutions and neither do most taxpayers in any of these countries.
Here’s the thing though. It’s not a black and white situation. I wish it were.
Last March, I also said the Irish really were following the Swedes, who everyone roundly praises for their response to a Swedish banking crisis in the early 1990s. Remember, in August 2008, I first mentioned the Swedish banking crisis response as the model response over the Japanese response from the same time period. (See my posts The Swedish banking crisis response – a model for the future? and Lessons from Japan’s Bank Crisis). Back in early 2010, I recounted how Matt Taibbi, Barry Ritholtz and I each felt that the Swedish model was the right one, instead of the all bailout all the time approach that is standard fare right now.
Clearly, the Obama people didn’t want this solution because they are captured by the financial services industry. That’s why the U.S. is going the Japanese route of bailouts and accounting dodges.
The Swedes of the mid-1990s did drag their feet too; they didn’t implement a draconian solution until it was obvious the system was insolvent. And I would add that the technology bubble bailed the Finns and the Swedes out. (Oil helped the Norwegians). So, without the boon for the likes of Nokia or Ericsson, where would those economies have been? Nevertheless, this is not the course the U.S. is on. The closest we have seen to this is Ireland – but even there I have had my doubts.
Did you catch that last sentence? Let me repeat it, because this is the sticky wicket: "The closest we have seen to this is Ireland – but even there I have had my doubts." Here’s a more complete commentary on the Irish/Swedish juxtaposition from the post from last March:
Ireland’s low debt and government surpluses have turned into a huge debt burden and massive government deficits because of the banking crisis – this in spite of, or should I say also because of, fiscal austerity. The Irish banks have recognized a huge slug of bad debt from the property developers. The question now is regarding residential property mortgage arrears and recognizing residential property losses.
When the banking panic happened in September 2008, Ireland issued sweeping deposit and bank debt guarantees. It was the bank debt guarantees that were the problem because of the size of Ireland’s financial sector relative to the domestic economy and government balance sheet.
I see a bit of historical revisionism going on here. In November, I wrote:
I have to point out again that the Swedes also gave bank debt and deposit guarantees when their banks failed in the early 1990s. So, despite everyone’s falling all over themselves to pinpoint this as the crucial reckless error by the Irish, there is precedent here. You should understand that the key difference is private sector debt levels in Ireland are some 700% of GDP because of the enormous size of the Irish financial sector. It is the Icelandic problem, not just the deposit guarantees, or even the debt guarantees, since other euro countries also guaranteed deposits (important that you see here).
P.S. – And yes, I talked about the bank debt guarantees here as a critical error as far back as November 2008 but only in the context of the large size of Ireland’s financial sector. I recommended deposit guarantees and think that partial deposit guarantees were a must in Europe in 2008 to stop bank runs. Moreover, other countries have the too big to rescue problem as well. It’s not just Ireland.
Everyone has patted the Swedes on the back for their successful 1990s bailout and crisis resolution scheme. That scheme was very similar to the present Irish one. The major difference is threefold:
- The Swedish banks were not as large relative to the domestic economy. The Swedish government could credibly backstop the banks and the debt guarantees.
- The Swedes have their own sovereign currency. That means currency depreciation helped the Swedes tremendously.
- The backdrop for global growth in the aftermath of the Swedish banking crisis was more favourable than it is presently
Take a look at this Chart of the Swedish Krona (SEK) to the US Dollar (USD). This covers the entire period from when Swedish central bank head Urban Bäckström took over at the Riksbank to when he wrote his review of the crisis in 1997. (See my post The Swedish banking crisis response – a model for the future? from August 2008).
The Swedish banking crisis began during the disruptive ERM crisis that culminated in the UK’s exit from the European Exchange Rate Mechanism of fixed exchange rates on Black Wednesday. The Swedes saw an enormous appreciation in the krona which helped to precipitate a banking crisis. But after Black Wednesday and Sweden’s attempt to fix the krona to the euro’s predecessor ECU by charging 500% for overnight money, the krona depreciated against the US dollar by some 40%. That’s an enormous move in a 15-month time span. That’s not going to happen in Ireland. In fact, the ECB is talking about raising rates – making the Irish situation worse. Irish residential property losses will increase under that scenario.
There is no way the Irish economy can go through austerity, which lowers consumption demand and economic growth, while paying the 5.8% ‘bailout’ rate of interest it has agreed to without ballooning its debt burden. The Irish are currency users. They have no sovereign currency, so it’s not a matter of printing up a gazillion Irish punts to ease the crisis. The ECB has made it plain that a full scale monetisation route is not going to happen unless we get an existential crisis (likely caused by a Spanish sovereign crisis). Default is the only way to ease this burden. And so the question becomes who will take the losses: Irish taxpayers, foreign bank creditors in Spain, Germany, the UK and France, or sovereign debt creditors. It’s as simple as that.
Conclusion: Ireland’s banking system was too big to bail like Iceland’s and therefore not salvageable like Sweden’s without massive bondholder haircuts.
I concluded this as far back as November 2008, shortly after the bank deposit and debt guarantees, asking Is Ireland the next Iceland? Put simply, the size of the banking sector in Ireland and the percentage of losses are well beyond the sovereign’s ability to handle without putting the sovereign at risk of default. So when Ireland was on the verge of collapse, precipitating its bailout by the Troika, I asked how the Irish can prevent a bank crisis from becoming sovereign default. The answer: "If Ireland is to save itself and prevent contagion, it will have to let bondholders take the hits instead of Irish taxpayers."
But that’s not what has happened.
And so now Irish taxpayers are rightly angry.
So, what is the right thing to do. Politically, it seems nigh impossible to allow bondholders to take the haircuts they deserve. Nowhere is this happening now. Bond investors made calculated capital allocation decisions. They misjudged the risk and must face the consequences. To bail them out is a moral hazard which encourages the misallocation of capital. And in Ireland’s case, and in Europe more generally, there is the question of economic nationalism to boot because the periphery’s creditors are foreign institutions. It’s not like the Irish government bailing out Irish creditors or the Greek government bailing out Greek creditors but more Irish and Greek governments imposing depression and huge debt burdens on Irish people to bail out foreign creditors. That’s some seriously combustible stuff.
But there is the systemic risk dilemma:
My problem here is that the holders of bank liabilities – depositors and creditors – have other options. They can always withdraw their support from an institution that they feel will fail – creating a self-fulfilling prophecy. This means that taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system. In the Swedish example from the 1990s, this was recognized and a blanket guarantee was given to all depositors and creditors of institutions deemed to be solvent…
This is a solution that was geared to address the ‘Bear Stearns problem’, where lines of credit are pulled and a firm goes under before it is clear that said firm is actually insolvent…
However unpalatable a senior debt guarantee might be, it seems a wise option to consider.
For an alternate take see Barry Ritholtz’s: Haircuts for Bond Holders.
-Stuffing bondholders, Mar 2009
I got into this in greater detail last June when talking about Stuffing bondholders in Greece and Ireland. The issue is separating liquidity and solvency. In a systemic crisis, the illiquid can be rendered insolvent. So, a credible senior bondholder guarantee can underpin the capital structure of a solvent organization and induce investors to roll over debt. That’s why the Swedes guaranteed senior bondholders in the 1990s. As I put it then:
To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster.
Bottom line: I side with the Irish journalist in the video below. He is rightly indignant that the Irish didn’t take the Icelandic route. That the Irish risked bankrupting the state was obvious almost from the beginning of the crisis. There is ZERO reason for the Irish people to bail out foreign creditors of a DEFUNCT Irish bank. The Irish government should repudiate their obligation to these bank debts as I have said many times before. Nonetheless, there is a kernel of truth in what Masuch says. The reality is that the Irish government had to make a difficult decision in determining whether to go the Swedish route or the Icelandic route. I think they made the wrong decision.
Hat tip Fred Sheehan.
P.S. – I wish this issue were black and white, but it’s not. The right thing to do is to provide liquidity at a penalty rate and let the insolvent fail if they can’t make the grade. Capital is misallocated if reckless and imprudent lenders are propped up artificially by government. The reckless lenders have every incentive to continue their reckless ways if they are bailed out. And so, this creates a Gresham’s Law with bad lending driving out good lending that ends in another systemic crisis. But, in a panic, you can never be sure whether the mood is so panicked that solvent institutions fail due to a liquidity crisis. And so without providing guarantees, you could provoke an unnecessary deflationary spiral.