Bank guarantee likely to deal a crippling blow to the economy
ANALYSIS:Government borrowing is not an immediate problem, but the extent of banks’ bad debts may prove catastrophic, writes MORGAN KELLY
BETWEEN COLLAPSING house prices, bankrupt banks and spiralling unemployment, you might be forgiven for thinking that fate has already dealt Ireland every misfortune in its hand. However, there may be one more unpleasant surprise in store for us, the prospect that international investors unexpectedly stop lending to the Government.
Economists call this a “sudden stop”. The original sudden stop occurred in 1998 when a default by Russia panicked lenders away from Latin America and plunged their economies into prolonged crisis.
The consensus among Irish economists is that government borrowing is not an immediate problem. Ireland has a low level of public debt by international standards, and even a few years of heavy borrowing will still leave it below Greek and Italian levels.
To understand why this view is too complacent, imagine that you are a bank manager and somebody that we will call Brian (not his real name) comes in looking for a loan.
Brian’s income is €30,000 and he would like to borrow €20,000 to cover living expenses. This sounds like a lot in these nervous times but, because Brian is not carrying much debt, you think you might lend to him.
However, Brian then lets it slip that, because his income is falling sharply, he will need to borrow at least as much each year for the foreseeable future. He also admits that, late one night and for what seemed like good reasons at the time, he somehow agreed to insure the gambling losses of some “banks”.
Brian has no idea how large these losses might be, but is starting to fear that they might be substantial. At this stage, you realise that Brian is on a trajectory into bankruptcy and show him the door.
Multiply the numbers in this story by a million and you begin to understand why Ireland makes bond markets nervous. First, the Irish economy is heading into a severe and prolonged slump that will force the Government to borrow heavily at a time when markets are increasingly reluctant to lend heavily.
Secondly, the Government’s delay in revealing how much its bank liability guarantee is likely to cost is making markets suspect that the final bill will be crushing.
After a decade of a credit-fuelled property bubble, the economy is not so much crumbling as vaporising: were we the size of Britain, January’s rise in unemployment would have been over half a million.
As the economy collapses, so does the Government’s tax revenue. This year the Government will have to borrow about €20 billion – everything it spends on wages or on social welfare – or about 15 per cent of a falling national income.
With no chance that the hopelessly uncompetitive economy will recover in the next five years and little sign that the Government has any appetite for serious cuts in spending or increases in taxation, borrowing looks set to continue at around this level for the foreseeable future.
If this borrowing was the limit of the Government’s liabilities, Ireland would probably just about weather the storm in the bond markets. Unfortunately, an elephant is lurking in the corner in the form of the bank liability guarantee, and this looks increasingly certain to sink the economy.
In my view, the Government has made insufficient effort to estimate how much its banks have lost. We have therefore had the bizarre experience of nationalising Anglo Irish Bank and recapitalising Allied Irish Banks and Bank of Ireland without knowing precisely the extent of their bad debts.
The Government has not updated its estimate of losses since Brian Lenihan’s boast that the liability guarantee was “the cheapest bailout in the world so far”, an assurance that already ranks in the annals of supreme political irony alongside Neville Chamberlain’s “peace in our time”.
The ability of the State to continue funding itself ultimately depends on the size of these bad debts. If they are of the order of €10–€20 billion, we will survive. If they are of the order of €50-€60 billion, we are sunk.
Irish banks could easily lose this much. If we suppose that most of the €20 billion lent to builders will not reappear this side of Judgment Day, along with 20 per cent of the €90 billion lent to developers, and 10 per cent of the €120 billion in mortgages, then we are already up to €50 billion.
These are only guesses. However, the continuing stream of revelations from Anglo Irish – which bear out the old investment dictum that there is never just one cockroach in a kitchen – suggest that they could be optimistic guesses.
To see what would happen to Ireland if foreign lenders suddenly pull the plug, we only need to look at what happened in Latvia last December. We would be forced to seek an international bailout, with the International Monetary Fund and European Union playing bad cop and good cop. We could expect cuts of one-quarter to one-third in public sector wages and social welfare benefits, and draconian tax rises to bring the deficit back to around 5 per cent of national income in two years.
There is actually a worse scenario where international bond markets suffer a general panic, like 1998. Not only does Ireland gets torpedoed, but also Portugal, Italy, Greece, Spain and Austria. The IMF and EU simply would not have the resources to bail out so many economies and we would be entirely on our own.
In circumstances where the Government could not even pay public sector salaries, the bank guarantee would immediately become worthless and we would see an uncontrollable run on all the Irish banks.
Watching the ineptitude and complacency of Lenihan’s bank bailout, we can understand increasingly how the people of New Orleans must have felt as they watched George Bush rescue their city: “Brianie: you’re doing a heck of a job.”
Particularly galling are the Government’s efforts to feign surprise and indignation at the behaviour of the banks, when the reality is that this is how we have always done business here. All that the Anglo affair has done is to hold up our grubby brand of crony capitalism for international ridicule.
For increasing numbers of ordinary people, the Irish economic miracle has turned out to be as worthwhile as a share in Bernard L Madoff Investments.
In return for working hard and paying their taxes, the lucky ones who keep their jobs can now look forward to pay cuts, negative equity and savage tax rises; while the unlucky ones face prolonged unemployment and losing their homes, their cars and everything for which they have worked.
If, on top of this, we suffer a sudden stop, people will see their pensions and Government spending slashed to pay off the gambling losses of Seán FitzPatrick and his pals. The Irish social fabric would certainly rip and unprecedented civil disorder ensue.
Bill Clinton’s feared enforcer James Carville once said that he would like to be reincarnated as the bond market, because that way you get to intimidate everyone.
Without decisive and intelligent Government action in the next few weeks, by the end of this year we will understand exactly what he meant.
Morgan Kelly is professor of economics at University College Dublin