Five years on from the bank guarantee decision of September 29th, 2008, debate continues to rage as to the role it played in Ireland’s financial and economic crisis. To many, the guarantee was a fatal error that led to a ballooning of Ireland’s debt and imposed huge costs on the citizenry for years to come.
This paradigm is simplistic and misleading. The big mistake was not the guarantee but the earlier policy errors and misjudgments that led to the property bubble, insolvency of the banking system and Ireland’s budgetary collapse. Defending the guarantee does not in any way imply a defence of these catastrophic failures.
The critical element underlying the guarantee decision was the firm view that no Irish bank could be allowed to fail, that is, closing its doors and defaulting on liabilities. Contrary to some assertions, this stance was not a diktat of the European Central Bank. It was the unambiguous policy of the Irish authorities ever since the UK Northern Rock crisis in mid-2007.
This policy was based on the experiences of widespread bank failures elsewhere that caused economic and financial chaos, in some cases (most recently in Argentina and Indonesia) accompanied by major social and political unrest, including violence and deaths. As panic began to engulf financial markets world wide during September 2008 (including in Dublin), there was a firm conviction that any Irish bank could not be allowed to become the Lehman Brothers of Europe.
Those who have forcefully criticised the decision have yet to present convincing arguments in favour of specific other options that would have succeeded in preventing a collapse of the Irish financial system at significantly less cost. Careful examination of all the possibilities available at the time leads one to conclude, as did the Honohan and Nyberg reports (and my recent book jointly authored with Antoin Murphy), that some form of comprehensive guarantee could not have been avoided – it was the least worst alternative.
Some have suggested that the decision should have been delayed in order to seek some better solution, perhaps involving European partners. However, faced with imminent default by Anglo Irish Bank the following morning and the prospect that the other banks would then very rapidly face similar intolerable liquidity pressures, it was imperative to take decisive and unambiguous steps that would be easily understood by the markets and restore confidence quickly. In the absence of such action, it is very likely that, after a short period of intense turmoil, the government would have been forced to introduce some form of guarantee. Meanwhile, Ireland’s financial reputation would have incurred incalculable damage.
Nor was there any reason to believe in 2008 that the ECB would alter its firm position that no bank should be permitted to fail and that the responsibility for intervention lay with national governments. Indeed in the subsequent five years no euro zone bank has failed apart from Cyprus recently. Moreover, possible pan- European arrangements that could involve burden sharing in dealing with troubled banks are still quite far from being agreed.
It has also been suggested that the Irish guarantee should have only covered deposits. Former taoiseach Brian Cowen and the late Brian Lenihan argued that the then prevailing Irish law would not have allowed a differential treatment of depositors and senior bond holders, a view that has not been challenged by legal experts to date.
In any event, if an unprecedented default vis-a-vis bondholders only had taken place in 2008 it is doubtful that depositors would have considered their funds to be safe, even if "guaranteed". For instance, deposits under €100, 000 covered by the traditional deposit guarantee scheme amounted to €65 billion – money the government did not have then or now. There would thus still have been a serious threat of a run on bank deposits.
Other options – obtaining liquidity by "raiding" the National Treasury Management Agency or the national pension fund, seeking extensive emergency lending assistance from the ECB, or nationalising Anglo – were considered at the time but discarded. They would have provided at best only temporary relief.
Neither would a guarantee of “new debt only” have addressed the problem. As argued recently by economist David McWilliams, when existing debt subsequently fell due, barring a major easing of financial pressures, it would have had to be replaced by new debt to try to prevent a run on liquidity. This would have had to involve a government guarantee of the same amount, leaving the exposure of the State unchanged.
Of course, in September 2008, the authorities held the fatally mistaken view that the banks were only facing liquidity, rather than solvency problems. The prevailing consensus was that there was no property bubble – by that stage house prices had fallen by only 8 per cent.
But even when the true size of the banking debacle subsequently emerged, the problem of bondholder debt, key at the time of the guarantee, would have remained. In November 2010 and again in early 2011, the Irish authorities developed proposals for burning senior unguaranteed bondholders. However even these proposals were rejected by the EU-IMF troika because of their broader systemic implications, in the former instance following direct US intervention.
By that stage, the dependence of the day-to-day budget on financing from the troika (for reasons quite apart from the guarantee) had robbed the Irish authorities of any effective negotiating power.
In conclusion, the guarantee decision, despite all its costly implications, was indeed the least worst option. What might have happened in its absence will always be a matter of conjecture.
However, unlike the approach of many commentators, a government's actions should be judged by assessing analytically the feasibility and implications of the alternatives available at the time. The heated debate on the guarantee has too often lacked such objectivity.
Donal Donovan, a former staff member of the IMF, was a member of the Honohan and Nyberg inquiry teams and is the joint author , with Antoin E Murphy, of The Fall of the Celtic Tiger: Ireland and the Euro Debt Crisis