Last month the eurozone sovereign debt crisis returned with a bang when the spiralling cost of borrowing to finance Irish debt rose too high and the Irish government was forced kicking and screaming to take European Union money to finance its banks and government debt.
At the core of this new crisis was Ireland’s banks and budget arithmetic. Even though the Irish have done many good things to address their fiscal deficits and have one of the most dynamic and liberalized economies in the EU, the budget arithmetic was still not deemed credible by the markets. Ireland’s primary deficit of more than 8% of GDP is well short of the 2% surplus needed to stabilize gross public debt to GDP. And the growth projections upon which the government bases its claim to return by 2015 to a total budget deficit of 3% of GDP (as required by the EU’s Stability and Growth Pact) look too optimistic.
Consequently, confidence throughout the system has been sapped by the state’s blanket guarantees of bank liabilities, the quality of the unfunded promissory notes used to recapitalize the banks, and uncertainties about the ultimate value of the bank assets that Ireland’s National Asset Management Agency (Nama) has been purchasing.
The feedback loops between the sovereign’s difficulties and the banking crisis in Ireland looked pretty nasty. And just at that moment, Germany said that it wanted private creditors to share the cost of any future eurozone debt restructuring (even if that was only when the European Financing Stability Facility – EFSF – expires). Although right in principle, it did not exactly help the flow of funds to the crisis-stricken European periphery.
This started to cause funding difficulties for Irish banks, which will only get worse if the country is downgraded by credit rating agencies, making access to European Central Bank funding more expensive and ultimately unavailable without an EFSF/IMF programme.
Self-fulfilling
So the psychological effect of all this was enough to force Ireland to discuss a bailout with other EU states. Bank deposits were falling and financial markets were closed to Irish banks, leaving the ECB as the last backstop. Although, the Irish state was fully funded well into 2011, the Irish banks were not. Markets could only become a source of liquidity again if financing from the EFSF and the IMF were in place. So the Irish crisis became self-fulfilling. It led to Ireland having to turn to the EU and the IMF for funding. Getting there was messy, albeit less so than in the case of Greece.
| Tough times |
| Private sector deposits with Irish banks and ECB funding to Irish banks |
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| Source: CBI, Independent Strategy |
The problem now is that, while default and rescheduling of Irish sovereign debt will be avoided, the process is contagious. The debt crisis could move on to Portugal and even Spain. And in the background, Belgium remains vulnerable. Indeed, Ireland is in many ways better placed to get out of its mess than the other so-called peripheral EMU states. Its economy is among the most competitive and export-oriented in the eurozone and its population is young (average age 35). It is therefore most likely to be able to produce the growth that an orderly reduction of sovereign debt needs.
There are two ironies in all this. First, Ireland is the only country to have implemented an orthodox Scandinavian-style cleansing of rotten assets in the banks and is being punished for doing so because the process inflicts pain up front, even though it leaves a solid financial and economic system for the future. That’s because it entails transferring the risk and recapitalization costs from the private to the public balance sheet at the outset. And when your banks are 10 times the size of the economy, as in Ireland, it’s obviously a problem.
Second, if Europe were to adopt the US Federal Reserve’s approach to monetary policy and sovereign debt, the ECB would be buying so much EU public debt that vice rather than virtue would be rewarded. But even though Europe is painfully hammering out the architecture of fiscal and monetary orthodoxy, this commands no premium in the market – at least not for now.
And yet the kernel issue that will cause the next financial global crisis is the debasement of money everywhere, except in the eurozone. That tells you that the value of eurozone government debt might suffer now, but the debt of the so-called QE countries, such as Japan, the US and the UK, will suffer even more down the road.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com