Wednesday, 25 February 2009

Ireland is bankrupt. Now let's get over it.

This piece has been cross-posted from Irish Left Review
Terrence McDonough - Goodbody Stockbrokers is predicting a decline in GDP this year of 6% unsettling public finances. Irish Nationwide has been downgraded by Moody’s to one notch above junk. Ireland is bankrupt. More specifically, its financial institutions are bankrupt, its government is bankrupt and, unfortunately, many of its businesses and citizens are bankrupt. But this is not as bad as it sounds. The admission of bankruptcy is the precondition of taking the necessary action which will help the country cope with the continuing economic crisis.

Let’s stop beating around the bush. Let’s look first at the banks. Ireland’s financial institutions are essentially insolvent. They may well be bankrupt right now. If they are not, they will be in several months time. Nobody who counts believes otherwise. This is most graphically evidenced by the fall in their share values to literally pennies. This raises three important questions. When will they go down? Who will take the hit? And what will replace them? The answers to all of these questions are in the grasp of the government. It must resolve to answer them and sooner rather than later.

When will they go down? They need to go down now. Government policy to date has consisted of indecisiveness masquerading as caution and elevated to the level of strategy. The Minister is hoping to muddle through. He is planning to extend the banks just enough government help to keep them going. This was first in the form of guaranteeing their deposits and their debts. Last week a minimal amount of capital was injected into the banks. The first of these options prevented a run on the banks but does nothing to resolve the problem of toxic assets and reluctant lending. Guaranteeing new debts taken on by the banks simply exposes the taxpayer to possible future losses. The promise of guarantees to new bond buyers should be rescinded immediately. Injecting capital may keep the banks alive for a little while longer but it buys the government a stake in a fundamentally dodgy enterprise. It also incentivises the bank managers to buy back the government shares instead of lending. This is to escape the required dividend payments and government oversight of their pay rates, bonuses, and continued employment.

Who will take the hit? Sadly the options so far pursued by the government put the ordinary taxpayer in the crosshairs. Other options under discussion will only make the problem worse. Providing the banks with public insurance against losses is obviously in this category. So too is the much discussed creation of a “bad bank” which will buy the toxic assets of the rest of the banking system. There was even talk by some commentators of using the now nationalised Anglo-Irish bank for this purpose - as if it wasn’t bad enough already. This option basically visits the past sins of the bankers on the general public. Interestingly, however, it is based on the principle that the only way to get things moving again is to purge the institutions of bad debt. This principle is correct and such a purge is one of the historic functions of economic downturns. Writing down debt allows individuals, businesses and the economy to start over again. The “bad bank” proposal seeks to create a “good” private bank by segregating the bad debt in a public financial institution. But wait a minute. Why not do it the other way around?

What should replace the current banks? We urgently need to create a publicly owned and operated “good bank” similar to that proposed by the Financial Times columnist and academic Willem Buiter. This institution (or institutions if some competition is deemed advisable) would assume the deposits of the existing banks. These are already guaranteed by the government in any case. The government would then purchase the good assets of the existing banks for the new good bank. Buying good assets has the advantage of paying a price set in the markets. Assets whose ultimate worth is uncertain and hence hard to price would be left with what are now legacy bad banks. The legacy bad banks would still be owned by their shareholders and would owe obligations to their bondholders. These groups would then assume the risk they contracted for in the first place. The legacy bad banks would be prohibited from accepting new deposits but would have the cash from the sale of their good assets as operating capital. One really attractive aspect of this proposal is that the existing management could be left to manage the remaining assets. If these guys (and gals) are as clever as their bonuses indicate perhaps they can dig the legacy banks out. But if not, there’s always the bankruptcy court with the owners, lenders and managers squarely in the gun sights where they belong. With the bankruptcy of the legacy bad banks, the financial system will be in the hands of the government’s good banks. The public will have dodged the bullet.

This is not necessarily a radical proposal. If you are conservative, the new banks can be privatised after a few years, perhaps at a profit for the state. If you’re a social democrat, the new banks can be kept in public hands and run like utilities providing the basic credit infrastructure of the private economy. If you’re a little more radical, the new banks can become the centre of a popular development strategy to cope with extended bad times. This may well be needed as the current downturn is one of the big ones like the Great Depression of the 30’s and the Great Stagflation of the 70’s and early 80’s. For this reason, the government’s Mr. Micawber strategy, muddling through until something turns up, cannot work with the country’s financial system.

Mr. Micawber won’t work with the public finances, either, which brings us to the second big bankrupt, the state. The state has not yet been forced to go cap in hand to the IMF, but to forestall this possibility, it has already defaulted on its previously agreed obligations to public employees. Dressing up a pay cut as a “pension levy” does not change the fact that the government judged itself unable to financially meet its commitments. Whatever about defaulting on its employees, a formal default on the government debt would be disastrous. The only option is to restore balance to the public finances. Some cuts are possible (all the junior ministers, the entire armed forces, and the Senate come to mind) but it was not overspending that brought us to this pass. It was an unsustainable tax structure based on unfairly taxing buyers in the property markets.

Incredibly the government’s response so far has contained no tax element. It is hoping for a recovery before it has to make this hard decision. This won’t happen. New tax revenue must be found immediately. Income tax must be raised across the middle and top of the income distribution with more than one additional tax band. All tax allowances must be placed on a short death watch unless specifically exempted by new legislation. Taxes on property or “rates” have been proposed. If it is right and proper to tax the kind of property an ordinary person might own, their residence, what’s wrong with taxing property across the board? Wealth is much more unevenly distributed than income. It can be moderately and progressively taxed on a yearly basis and more heavily taxed when inherited.

This brings us to the small bankrupts, businesses and individuals. Here our proposed bank reform can help. Good public banks can bridge cash flow problems for solvent businesses by resuming lending, preventing unnecessary bankruptcies. On the other hand, the legacy bad banks can stop pretending to be solvent by pretending their bad loans may still be collectable. Bankrupt business assets can be sold to solvent businesses at attractive prices. Bankrupt entrepreneurs can start over cleansed of debt. Family homes should be protected, but unpayable private debt should be written down in bankruptcy proceedings. Bankrupt individuals may be denied their credit cards, but they can stop paying interest and start buying products and services again.

The old model worked for a while. The Celtic Tiger period brought an increase in Irish prosperity which may not be fully lost in the current downturn. But it created a highly unequal society addicted to unsustainably low taxes, an unsustainable property bubble, and unsustainable debt. This model has come crashing down as we secretly knew it must. The old model cannot be reconstructed, but the crisis may bring the opportunity for the creation of a more sustainable alternative. Another Ireland is possible. We must stop dithering, act decisively and act now.

Terrence McDonough is professor of economics at the National University of Ireland, Galway

5 comments:

Gerard O'Neill said...

Strangely enough I find myself in agreement with most of this.

Tomaltach said...

Believe me, I am no apologist for the current government. And they are doing a desperate job of handling the current crisis especially in terms of leadership and formulating a strategy.

Yet I think some of the criticism in your post is too easy. For example "Buying good assets has the advantage of paying a price set in the markets. Assets whose ultimate worth is uncertain and hence hard to price would be left with what are now legacy bad banks. The legacy bad banks would still be owned by their shareholders and would owe obligations to their bondholders. These groups would then assume the risk they contracted for in the first place."

There are a couple of problems with this. First, you divide assets into those "whose ultimate worth is uncertain" and those which are presumably sound. But this division can hardly be easy. The market is effectively in a state of stall. When it functions the market provides a clear price or value signal but right now it is producing what might be termed noise. Very few assets therefore have a clear value.

The second issue is, even if we could categorize assets, what if most or nearly all were in the bad category? Then there would be effectively nothing left from which to form the 'good' banks.

And finally, the statement "those groups would then assume the risk they contracted". In theory yes. But this paints all stakeholders with the same dirty brush. True at the heart of the banking system there were systemic problems with risk evaluation, there was also a certain culture which led to catastrophe and of course there was plain old corruption. There also was poor regulation. But at the time when many stakeholders bought in, they were not knowledgeable about the systemic problems or the fact that regulation was insufficient. Take a person who say invested 20k in Anglo ten years ago. Or BOI for that matter. Based on the information at their disposal, the investment was pretty sound. True as the property bubble grew it might have been time to get out. Yet, even if one feared a significant market correction, no one could have know there'd be effectively a systemic breakdown. In that sense, I think it is a unfair to just say to hell with all stakeholders, the market is a risky place, too bad.

If that is the attitude, then how can it ever restore investor confidence. True we may end up publicly owning the banks and perhaps there is a case for long term ownership, but if investors are not just required for banks, they are also required for say our green economy, for our attempt to build a high tech economy etc. So yes, investors take risk and should assess it and so on, but we are now living through an extraordinary breakdown and we need to take steps to restore confidence.

Terry McDonough said...

Apologies to tomaltach for the delay in this reply.

If there aren't enough good assets to cover deposits, the banks are really, really bankrupt. The government will have to cover the difference. This makes compensating bondholders as well even less affordable.

Not every bondholder is a villain. A lot of stockholders are also relatively innocent. But in the current breakdown someone must take the hit. The Irish government is like the Icelandic government in that the economy is not large enough to cover the potential banking losses. So the bondholders and stockholders must lose. Better to do this quickly and establish solvent institutions. Past bondholders will be none too pleased. But there will be no reason to punish the new good institutions for the behavior of the old. Indeed such vindictive action would be inconsistent with private profit maximization. The quicker we move to good public banks unencumbered by the old bad debts the sooner this realization will dawn on "the markets".

Terry McDonough

Anonymous said...

Ever since the dawn of recorded history, Ireland has been principally a land of childish, tribal squabbling. Anyone harbouring expectations of such a society ever becoming a meaningful part of civilised Europe was, and still is, committing an act of gross self-delusion.

The creation, in 1916, of the myth that Ireland is capable of rational and equable autonomy in an increasingly sophisticated European context has spawned most of the present day mayhem. Ireland is a collection of anarchic partisan elements pretending, with an increasing feeling of inadequacy, to be a proper country.

Nothing in the Irish social or economic structure, such as it is, works correctly. Its healthcare system is a loosely thrown together amalgam of the very worst features of every failed system that has ever existed; its transport infrastructure bears greater resemblance to a retarded child playing with a train set than it does to anything else in contemporary Europe; and its education system remains shackled to the mind-boggling repression of individual creativity which has always been the hallmark of the Roman Catholic church.

To see Ireland toying helplessly with the responsibilities of nationhood is like watching a child who has been given a $100 bill rushing straight to the sweet shop to buy as much chocolate as possible, and then sitting at the roadside wondering why he is vomiting so violently.

Every modern commercial enterprise in Ireland which is in the least successful is steered by either the Americans or the British. To expect an agrarian hand-to-mouth culture to develop overnight into a burgeoning 21st Century high-tech beacon is to expect a miracle. Rote-learning is not a substitute for innovation; 'monkey see, monkey do' not an adequate replacement for comprehension.

The bubble had to burst, sustained as it was by the illusion of belonging to a world a million miles from what Ireland actually is, and by the insatiable greed of the man who mistakes wealth for value and the international drivel of the plasma screen for culture.

Grow nice potatoes, make nice butter, export them to the rest of Europe. Do what you actually CAN do, but please don't perpetuate the sorry shambles of trying to become what you are not.

Michael Burke said...

Anonymous

There's nothing like an uplifting, concise, nuanced evidence based perspective.

Back in the real world, maybe the 1916ers weren't so misguided as you think.

Since 1948 the British economy has grown by 4.25 times in real terms. The Irish economy has grown over 12 times.

Sometimes you can learn a lot from 'children'.