Unless the ECB takes fast and dramatic action, it risks destroying the currency it is paid to manage, and allowing a political catastrophe to unfold in Europe.
If mishandled, Ireland could all too easily become a sovereign version of Credit Anstalt – the Austrian bank that brought down the central European financial system in 1931, sent tremors through London and New York, and set off the second deeper phase of the Great Depression, the phase when politics turned ugly.
-Ambrose Evans-Pritchard, Telegraph, 14 Nov 2010
I reckon it is actually Greece which would be the Credit Anstalt event. The demise of Credit Anstalt triggered a collapse in Austria. This then went via contagion into a German bank run and an attack on Sterling before a run on the US dollar brought the whole global system into chaos. See my brief synopsis here. We have already had the first real run – on Greek sovereign debt. What we are witnessing now with Ireland is the first real escalation beyond that trigger event.
Last Thursday I wrote about a German-language Handelsblatt article which was the first real hint that preparations were being made for an Irish bailout (see here). My thoughts in that article were:
There is no way the Irish are going to be able to make the budget adjustment "aus eigener Kraft." This is not credible. Denial is only going to make this worse. The time to act is now.
Since then, there have been consistent denials by Irish government officials followed by further reports corroborating the original Handelsblatt story. At this juncture, I don’t think Ireland has credibility with anyone in the market, frankly. Everyone assumes this will go to the IMF and the EFSF like Greece. Here’s the problem, as Marshall Auerback put it to me:
Looks like this is just extend and pretend like Greece. In neither case is the problem actually dealt with. The EFSF facility won’t work in any case. It’s like asking the other 49 states to bail out California. You need the involvement of the ECB. There’s another problem: the hope is that the EFSF will be able to issue triple A-rated debt guaranteed by all eurozone members except Greece and, now, presumably, Ireland (in fact, any nation seeking help is excluded). Ironically, as the number of eurozone nations receiving help from the EFSF grows, the number backing that debt decreases—making it less likely that EFSF debt can retain the highest rating. From what I understand, it appears that any nation that cannot float debt at an interest rate less than 5% would be able to borrow from the EFSF at a lower rate. Portugal recently found itself in that category, after auctioning debt at much higher rates, and while it has denied it would seek help, the better terms it could obtain at the EFSF must look attractive. In any case, only 40% of the nations that stand behind the EFSF’s debts are themselves rated AAA—so what we have is mostly lower-rated governments guaranteeing EFSF debt that hopes to get an AAA rating. At least on the surface, that arrangement seems fishy. If more countries get downgraded and if more need to seek assistance, it is possible that the guarantees will not be sufficient to allow the EFSF to issue the full €440bn precisely when the full amount is most needed.
It’s a bit like a huge CDO, where the whole thing is rated AAA, even though a large chunk of the tranche is "subprime". And we know how well that worked out in the US mortgage market!
But remember, the Irish have domestic concerns to think about. That’s the reason for the extend and pretend. Sure, I think this is going to the IMF and the EFSF. But I think you need haircuts to existing bondholders for this to have any credibility. The problem is
- the Irish corporate tax regime. Many in the EU want to get Irish taxes up and will use the EFSF as a Trojan horse for doing so.
- the Irish are worried about their institutions falling into foreign hands. Foreigners taking over is what one has seen in weak banking systems in E. Europe and Latin America.
The Irish will do everything they can to avoid the IMF and the EFSF as a result. But If Ireland is rescued, it will be on to the next debtor, Portugal, anyway. And, as Marshall was saying, the more bailouts you perform, the fewer the number of nations left to support those bailouts. So Portugal’s the end of the line, frankly. There is no way the EFSF can support a bailout of Spain. Nor would the Germans put up with this after Greece, Ireland, and Portugal. So, as Marshall told me:
Haircuts are inevitable, but can you do that without precipitating a banking crisis. That’s probably the only thing holding back the Germans.
Irish taxes going up does not solve the problem. It’s another form of austerity which will simply exacerbate the current debt deflation dynamic. Terribly futile. The Germans are picking the wrong time to punish the Irish for their tax and regulatory arbitrage.
I think that’s where the Evans-Pritchard article comes in. The Irish are dead men walking. Portugal is coming next and Spain is too big to bail. So you have to have haircuts for existing peripheral bondholders despite what the European politicians are saying. See Europe’s Monetary Cordon Sanitaire by Simon Johnson and Peter Boone. They argue we are definitely getting to the point where haircuts for existing debt holders is going to make sense for the peripheral governments. The numbers they use suggesting haircuts are very compelling. And everyone knows this; that’s why the debt is selling off. However, If the bondholders get haircuts, or if we see sovereign defaults, do you really think the German and French banks have enough capital to withstand this loss? I have my doubts. Eventually, people may come around to Evans-Pritchard’s view: the only way out of this is via the ECB printing money and monetizing the periphery’s debt. And implicitly that means a competitive currency devaluation for the euro zone.