Things are going to get much worse

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ANALYSIS:This is the future: without immediate Government funding, bank lending will fall by three-quarters, driving most companies in Ireland out of existence, writes Morgan Kelly 

BY SHOOTING itself in the other foot over the Budget, the Government has temporarily diverted attention from its botched bailout of the banks, but the problem has not gone away. While financial markets across Europe are beginning to stabilise, Irish banks continue to sink deeper beneath the waves and are starting to drag the rest of the economy under with them.

What makes bank crises economically catastrophic is that they cause credit squeezes which drive profitable firms out of business. Every company in Ireland relies on a credit line to pay wages and other expenses between payments from its customers.

Established firms (outside construction) rarely go out of business because they are unprofitable, but because they have problems with cash flow; and any firm that loses its bank credit line is effectively dead.

The amount that a bank is allowed to lend is proportional to its capital. When a bank loses capital through bad loans, as Irish banks have done spectacularly through their lending to builders and developers, it must reduce its lending. Already many smaller firms are finding it harder to get overdrafts, and the worst is yet to come.

If we suppose that the current stock market valuations of Irish banks are a rough indicator of the true book value of their capital, then in the next year we can expect banks to write off more three-quarters of their capital as bad debts. This means that without immediate Government action to recapitalise the banks, bank lending will fall by three-quarters, driving most companies in Ireland out of existence.

The Government claims that the merit of its scheme is that it costs nothing. Unfortunately, international experience shows that when banks get into trouble, the choice is not whether you spend money, but when. Either you pay the money up front to recapitalise banks; or you pay far more over the next decade in bankruptcies, unemployment and lost output.

It was knowing how credit contractions wreck economies that led the British government, followed by the French, Germans, Spanish, Swiss, Dutch, Swedes and Americans, to do the right thing and move swiftly to recapitalise their banks.

These measures appear, thankfully, to be working. The hope among economists here was that good policy would drive out bad, and that the Government would abandon its ill-conceived bailout and follow suit.

In the event, the Government chose to persevere with a scheme that serves only to keep zombie banks going while starving their customers of credit; and helps nobody apart from some developers and bankers.

Irish bank executives can continue to draw their pay and hope eventually to trade their way out of their problems.

In a few months, they assure us, people will again be flocking to buy in ghost estates, deserted office blocks will be thronged, and our troubles will be behind us.

It is worth recalling that the last time Ireland's wealthiest businessman and his dodgy personal bank got into financial difficulties - Patrick Gallagher and Merchant Banking Ltd in 1982 - both were allowed to go bankrupt. Gallagher eventually did two years for fraud in Crumlin Road Prison, Belfast.

I predicted early last year that falling sales and property prices would cause the building industry to collapse, which would in turn leave banks practically insolvent. However, I could not have conceived how, faced with a cancer of bad loans that had eaten through our financial infrastructure, the Government would slap on a band-aid of liability guarantees and walk away, leaving the Irish economy to its fate.

The liability guarantee leaves Irish banks in precisely the position of Fannie Mae before it was nationalised: alive but economically useless. In effect, the Government has chosen to inflict a Japanese-style lost decade on the Irish economy.

What the Government should have done was to offer substantial capital to the four worthwhile banks that Irish firms and households rely on for credit; and to close down the other two which were effectively conduits for real estate speculation with no role in the wider economy.

Instead, it guaranteed the liabilities of even the worst two "banks" without checking what, if anything, their assets are worth. By doing this, the Government has put the taxpayer at risk of substantial losses, and compromised its ability to provide adequate capital to the banks that need to be saved.

These points are so obvious that it is almost embarrassing to repeat them. Even with the strikingly poor quality of economic advice available to it, the Government knew what should be done, but decided to do otherwise. What impelled these politicians to make the worst economic decision of any Irish government in the last 30 years?

In the last decade, Fianna Fáil came to see developers and the banks which funded them as the real heroes of the economic boom: the men whose drive and vision had given us an economy that was the envy of Europe. From bywords of ineptitude, Irish builders and bankers were transformed into masters of the universe. What was good for Anglo Irish Bank was good for Ireland.

Three weeks ago, bubble turned irrevocably into bust. Brian Lenihan was faced with a choice between rescuing two banks and the handful of developers through whom they placed real estate bets, or recapitalising the financial infrastructure on which the other four million of us depend.

He chose the former. The grave consequences of this extraordinary decision, both political and economic, will ensure that in the coming months we shall all get to live in interesting times.

Morgan Kelly is professor of economics at University College Dublin

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