ECB-IMF deal is a noose that will strangle economic recovery

Sat, Apr 9, 2011, 01:00

OPINION: What the ECB and IMF have forced on Ireland is fundamentally corrupt and doomed to failure, write MICHAEL CRAGGand JOSEPH STIGLITZ

WHAT HAPPENED to the Celtic Tiger? For many years, Ireland’s growth was based on fundamentals: investing in education and infrastructure to make the country an attractive place for investment and a gateway to Europe for companies from the US and Asia.

But then, like so much of the rest of the world, Ireland was distracted by the lure of fast bucks and the wizardry of finance. As in much of the rest of the world, false economic doctrines advocating unfettered markets prevailed, claiming the seeming success of the economy as evidence of their verity. Not surprisingly, economic doctrines that helped create the crisis have not served the country well in dealing with its aftermath.

With those still in office entering into international lending agreements that benefit the Irish banks and their debt holders but not necessarily the Irish citizens, fundamental questions arise about how to move forward.

Today, those fundamentals that created the Celtic Tiger are still there, but the real resources, the most important of which are its people, are increasingly sitting idle. Unless the right policies are put into place, matters are likely to get worse.

Unfortunately, the question of which policies are right is being distorted by an effort to “save” the banks. The new Irish Government, after the old was tossed out for its dismal failure at managing the crisis, had (and still has) the opportunity to put Ireland on a more sustainable path, but has failed thus far to address the underlying problems.

There are two fundamental interrelated problems. What to do with the banks? And how to get the economy started again? We know policies of austerity will lead to lower output and lower tax revenues, and if there is any improvement in the deficit, it will be smaller than expected. What matters for debt sustainability is the ratio of debt to gross domestic product (GDP); the higher the ratio the more unsustainable the economic trajectory.

Even in more optimistic scenarios, Ireland’s debt to GDP ratio is expected to soar to 125 per cent in 2013, up from 25 per cent in 2007. Low growth could make things worse, as stagnant GDP offsets the reduction in Ireland’s debt. If Europe continues to falter – 2011 growth is projected to be lower even than last year – this will make Ireland’s recovery all the more difficult.

Even the EU is now anticipating that projections made just a short while ago were too rosy. But the EU recipe for recovery is more of the same: to meet the deficit reduction targets, more austerity – which in turn means still lower growth and still higher unemployment.

In effect, the International Monetary Fund (IMF) and European Central Bank (ECB) are asking ordinary Irish workers and citizens to bear the burden of mistakes that were made by international financial markets. But it is important to recognise that these mistakes are at least partly attributable to following deregulation and liberalisation policies that were advocated by the IMF and ECB and that these policies provided significant benefits to the financial sector.

Irish citizens bear the costs of these mistakes not only through higher unemployment, but also through lower wages, higher taxes and cutbacks in public services. That there will have to be some cutbacks is inevitable, but it is not inevitable that they be of the current form or magnitude. The Government’s steadfast and continuing policy of bailing out the Irish banks and their bondholders is at great personal cost to Irish citizens. The fundamental economic policy question is who should bear the costs of the mistakes. And this is where the first question, what should be done with the banks, links with the second, how to reignite the economy.

Under capitalism, those who provide capital, whether through bonds or equity, are supposed to oversee what is done with their funds; this accountability is what makes capitalism work. It is the system of incentives that underlies the success of a market economy. We tolerate a high degree of inequality in defence of these incentives – it is argued that high rewards are necessary to compensate for risk and to motivate responsible entrepreneurship.

In Ireland, as in much of the rest of the world, though, those who seemed to believe in markets, started to rewrite the rules in the midst of the crisis. They argued for the socialising of losses, while the gains had been privatised. Such a system of ersatz capitalism is doomed to failure, and is fundamentally corrupt and inequitable. Some argued that globally it was necessary to support the too-big-to-fail financial firms but this logic certainly doesn’t apply to relatively small institutions in a relatively small country at the cost of its citizens. There are alternatives.

Many Irish citizens now realise the cost of bailing out bondholders (whether in Germany, the US, the UK or even Ireland) is being borne by them. It is a massive, unjustified and unjustifiable redistribution of resources.

The IMF and ECB are lending money to ensure Irish taxpayers bail out Irish bank bondholders, but with little concern for economic growth and welfare.

The international lending terms imposed on the Government and its citizens are onerous in large part due to the Government’s continuing policy of bailing out the Irish banks. Raising interest rates to Ireland to tame European inflation is senseless. The budgetary “correction”, arising from higher taxes and lower services to pay for interest on the debt, will balloon to over 6 per cent of GDP and cumulatively amount to 9.6 per cent of GDP.

But Ireland should realise this may be only the first step in the bloodletting. As we noted, already there is recognition the Government underestimated the adverse effects on the economy – and thus overestimated tax revenues and the budget. But even worse, there are grounds to believe the €85 billion may be inadequate because of the ongoing posture towards the banks.

No one can be sure what will happen with the economy or the banking sector and therefore judgments about the adequacy of the international lending package are contentious. This is in part because the answers depend on the policies pursued. If the austerity programme continues, the economy will slow, defaults will increase and property values will decline even further.

Sometimes countries are faced with unpleasant choices. And there is a tendency when facing those unpleasant choices to avoid making the hard decisions. But there are high costs to postponing facing reality.

Under the current strategy, under “rosy” scenarios, Ireland’s debt to GDP ratio will quickly reach 125 per cent. Think what that implies. Assume that Ireland doesn’t try to repay the money, but just pays the interest, and assume that market interest rates return to something more “normal” – compared to the current very low rates resulting from the flood of liquidity from the ECB and the Fed. A country with a debt to GDP ratio of 125 per cent could easily have to pay 8 per cent interest rates. This would mean that 10 per cent of Ireland’s GDP would have to go forever to just service the debt.

This is a noose around the country’s neck that will strangle it. It makes clear the IMF, ECB and Government must come to terms with imposing losses on the international lenders whose loose lending policies played a central role in the current crisis.

Debt restructuring is neither easy nor costless; but the costs are far less than the alternative. Argentina, after its debt restructuring, grew at an average annual rate of more than 8 per cent for six consecutive years until the global economic crisis hit. Ireland, with its talented people, its location, and the advantages provided by being in the EU, would be in an even better position.

After restructuring, Ireland would attract new banks and new firms that would see these fundamental strengths. In contrast, continued delay in dealing with the inevitable day of reckoning will cast uncertainty over the economy: so long as there is not debt restructuring, the country faces low growth, high taxes and/or low public services, a disgruntled labour force and citizenry that has been made, unfairly, pay for others’ mistakes.

And so long as there is not debt restructuring, economic risks of a highly levered economy and associated uncertainties of a future debt restructuring and its consequences will discourage investment, both domestic and foreign.

Those representing the interests of the lenders (bondholders) have, of course, a different view. They want to extract as much out of the Irish people as they can.

The new Government faces hard choices. Any path presents risks. If there were reasonable prospects of avoiding the turmoil that might result from a debt restructuring, we could understand why one might gamble on the strategy of postponement. But as we look at the numbers, the hard facts suggest otherwise. It is time to get the Irish economy back to work. The current strategy will simply increase the gap between the economy’s potential and actual output, and lengthen the time before a return to full employment.

And even were it to succeed, it will mean Ireland will be in partial indentured servitude for as far as the eye can see – devoting 10 per cent or more of what it earns to pay off what are largely the consequences of the financial sector’s misdeeds. There has to be a better answer – and there is: international loan loss recognition combined with pro-Irish growth policies will be better for all in the long run.

Joseph Stiglitz is university professor at Columbia University. He was awarded the Nobel Prize in economics in 2001. He formerly served as chairman of President Clinton’s Council of Economic Advisers and chief economist at the World Bank. Michael Cragg, an economist who formerly taught at Columbia University, is now a principal with the Brattle Group.

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