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Analysis/Comment Last Updated: Nov 23, 2010 - 5:11:12 AM


Ireland's EU/IMF Bailout: The Euro is not to blame
By Michael Hennigan, Founder and Editor of Finfacts
Nov 22, 2010 - 6:49:22 AM

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Nov 13, 2010 - - An EU bailout doesn’t “make any sense” Lenihan: During the course of an interview with RTÉ Radio Minister Lenihan said “We’ve substantial reserves. We have the pension reserve fund. So this country is not in a situation or in a position where it is required in any way to apply for the facility. So why apply in those circumstances it doesn’t seem to me to make any sense?”

Ireland's EU/IMF Bailout: It is easy to blame the euro for Ireland's economic woes and it's typical in situations like the current one to search for scapegoats beyond our shores.

The issue of the responsibility for euro for Ireland's economic bust is 1) a separate issue to whether Ireland should have joined in the first place, with its clientist system of local politics that produces political leaders from teachers, property auctioneers, small-town solicitors, hospital administrators and farmers, coupled with vested interests from across the spectrum dedicated to grabbing what they could from the public treasury, 2) the role the European Central Bank may have had in Sept 2008 in forcing the Irish Government to protect 'systemic' banks.

The Irish Central Bank publicly declared its impotence before launch of the euro and futilely pleaded for restraint from the banking sector as fiscal policy fuelled the boom. In contrast, Spain's biggest banks survived a huge housing boom because the Spanish central bank insisted on additional provisioning during the good years and other risk controls.

Simply put, in Ireland, there was no counter to reckless fiscal policy, from the Central Bank, as it had declared its impotence almost two years before the launch of the euro. The Spanish central bank took a diametrically opposite approach.

Central Bank governor Maurice O'Connell, told the Oireachtas Committee on Finance and the Public Service in early 1997: "There seems to be a perception that the Central Bank can exercise some legal authority in restricting credit. It has no such authority. Any restriction would be inconsistent with European Union practice. Besides, it would be unworkable as demand would probably be met by overseas lenders."

He said the Bank had warned financial institutions repeatedly of the dangers inherent in high rates of credit growth and any relaxation of lending standards.

In the following years, as Finance Minister Charlie McCreevy stoked the property boom with income and capital tax cuts coupled with a massive expansion of property tax incentives, the annual reports of the Central Bank chronicled the letters that were sent by the governor to the financial institutions, pleading for prudence.

The bankers must have been laughing up their sleeves!

In April 1999, the governor had issued a letter stating that an analysis of practices had shown that some lenders had no evidence as to how borrowers came by the balance of their money. The governor criticised what he called, the particularly disturbing practice of allowing large amounts of the borrowers after tax income to go towards paying off a mortgage.

The 1999 annual report notes: "Institutions were...advised that it remains vitally important for them to take a medium term perspective and to reckon with the potential consequences of rising interest rates and a return to lower rates of growth in the economy. All institutions gave assurances that there would be no slackening in prudential lending standards."

In April 2000, the US magazine BusinessWeek, quoted the governor: ''There's no monetary policy prescription for the problems of the Irish economy.''

The Irish Central Bank didn't even bother to gather data from the banks on 5-year interest only mortgages, which were the mainstay of the buy-to-let property market.

Discussing the EU-IMF bailout for Ireland, Torge Middendorf, economist at WestLB, says the deal will help ease fears of a contagion in the short term and bring down the yields of Portugal's government bonds. He talks to CNBC's Chloe Cho and Anna Edwards:

In 1999, the year of the launch of the euro, the Bank of Spain agreed to put in place in 2000 a new solvency provision, the so-called statistical or dynamic provision, forcing its main banks to provide additional ‘rainy day fund’ reserves and in contrast with the Irish banks, risk management at Spanish banks was already central to their operations.

A World Bank paper published in 2009 says Banco de España and its banking supervisor, put a system for special loan-loss provisions, in place in July 2000, to cope with a sharp increase in credit risk on Spanish banks’ balance sheets following a period of significant credit growth. Moral suasion had proved to be inadequate in inducing banks to become more conservative. Moreover, intense competition among banks had resulted in inadequate loan pricing - - that is, risk premiums were too low. The new system in effect obliged the banks to build up a fund for the rainy day.

The World Bank paper says Spanish banks had accumulated a significant buffer to cover incurred losses, a buffer that they have now started to draw down as individual loan losses have begun to mount in parallel with the deterioration in the economy. The buffer was never intended to be permanent. Instead, it is meant to be used in periods such as the current one, when problem loans and specific provisions are surging. By being drawn down, dynamic provisions fulfill their anti-cyclical purpose.

Besides central bank intervention, an intense board-level focus on risk is another reason why Spain’s large banks have so far weathered the credit crunch in better shape than many of their European rivals.

The risk committees of the two biggest banks, Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA), include several external non-executive directors and they meet usually more than one each week.

Spain has had problems with its politically controlled ‘caja’ banks but not its principal banks.

When Ireland joined the euro, it needed to have a prudent fiscal policy but when the European Commission and ECB criticised the 2001 Budget, the ICTU congress of trade unions and employers' group IBEC, strongly supported the tax cutting strategy of the then Minister for Finance, Charlie McCreevy. One year ahead of a general election, an Irish Times poll also showed strong public backing for McCreevy and Taoiseach Bertie Ahern.

Bank of Ireland economist Dan McLaughlin argued for medium term income tax targets of 30% and 10%.

This ‘miracle’ was going to go on forever.

Three years later, Damian Kiberd wrote in The Sunday Times: “We need strong leadership at the Department of Finance. The sort of leadership that will ignore calls from Oireachtas committees, NESC and academic economists for substantial interference in the whole property and construction sector.”

In the same year, the Oct 2004 Economist survey said: "Ireland is not the only country to have experienced a housing bubble in recent years. But it may be peculiarly vulnerable, because as a member of the euro area it cannot raise interest rates in order to prick the bubble. Moreover, in the past decade or so property and construction have become unduly dominant in the economy. This year, for example, Ireland is on course to build almost 80,000 new houses. Britain, which has 15 times as many people, builds only twice as many. Employment in construction has almost doubled in the past decade, and the sector accounts for some 15% of national income—over twice as much as in Britain.

The banking system is heavily exposed: the big Irish banks, such as Bank of Ireland and Allied Irish, are in effect mortgage banks, observes Colm McCarthy of DKM Economic Consultants. A property crash would badly hit their balance sheets."

Interest Rates

The ECB reduced its benchmark rate to 2% in June 2003 and the rate was hiked to 2.25% in Dec 2005.

The Bank of England rate was 3.75% in June 2003 and 4.5% in Dec 2005.

The argument goes that the low rates benefited Germany while they fuelled the property boom in Ireland.

In Ireland, in 2005, Davy Stockbroker economist Rossa White, used what economists call the Taylor Rule, to estimate the appropriate interest rate for Ireland as 6%, compared with the then ECB policy rate of 2%. The contemporary rate in Iceland was 8.25%.

Membership of the euro system is incompatible with casino economics. The option of devaluation and a quick route to restoring competitiveness isn't available in a downturn. In Iceland, with its own currency, the high interest rate attracted foreign money to fund reckless adventurers, who put their economy on the road to ruin.

In Ireland, it's a fanciful notion that outside the Eurozone, a boomtime Irish fiscal policy would have been matched by a prudent monetary policy.

Apart from the example of Iceland with its own central bank in charge of monetary policy, even allowing for a foolish trust in the independence of an Irish central bank, the argument that as Irish trade was primarily with the US and the UK, also does not support the anti-euro argument. The Euro is the world's second reserve currency and US companies generally do not repatriate profits unless they have no funding requirements overseas.

It's instructive to note that no senior manager in the civil service or the central bank had the courage to publicly oppose irresponsible economic policies including the special benchmarking payment that was based on a false premise. Self-interest always trumped principle and simply, nobody stood up to the reckless politicians.

Academic economists were also reluctant to tell the emperors that they had no clothes.

So to have expected prudence at the Central Bank, controlled by former staff of the Dept of Finance while Fianna Fáil politicians would have countenanced high interest rates to dampen business for its builder friends, is ridiculous.

Besides these people on Dame Street were the ones singing the mantra about ‘resilient’ banks when they were in fact insolvent. Would they have been better overseers of monetary policy?

Epilogue

In or out of the euro, feckless politicians with the support of the majority of Irish people in a bout of property hysteria; against the backdrop of a global credit boom and capital in search of yield; we would have had the same outcomes at a time of a severe global recession.

The aftermath would be likely worse outside the euro.

Devaluation can be a temporary palliative for commodity producers - - (Iceland- fish; Argentina - - beef and wheat) and the Finnish devaluation in the 1990s increased its national debt by 40%.

Decisions regarding the destination of most Irish exports are not even made in Ireland; besides, why isn’t the UK enjoying an export boom after a 20%+ trade weighted devaluation since 2007?

As for the ECB and the blanket bailout in Sept 2008, which guaranteed all bank debt, it was up to the Government to reject the classification of Anglo Irish Bank as a 'systemic' bank, which it wasn't.

The ECB noted in an opinion in Oct 2008 that uncoordinated decisions to guarantee interbank deposits in some member states should be avoided.

More information on the interaction with the ECB should be made available but it was the Irish government that made the final fateful decision to guarantee existing bank debt.

It was the only Eurozone member to do so.

Irish Economy: The 2001 economic consensus that paved the road to economic ruin

Ireland and leaving the Euro: 10 questions for pub-stool economists

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