Whatever It Takes
Lord Melchett: “Farewell, Blackadder [hands him a parchment]. The foremost cartographers of the land have prepared this for you; it's a map of the area that you'll be traversing. [Blackadder opens it up and sees it is blank] They'll be very grateful if you could just fill it in as you go along. Bye-bye.”
– From the English comedy series Blackadder (Part 2, Episode 3)
Was it only a few years ago I visited the Emerald Isle of Ireland? So recently had this fair land come to such a sad state. The collapse of its largest banks foreshadowed the demise of many other European banks that had borrowed money from British, German, and other European banks to lend against homes and property. The Irish government had to guarantee deposits and bond holders in order to prevent a bank run. I think I am correct when I state that the Central Bank of Ireland was the first central bank to avail itself of large-scale use of the Emergency Liquidity Assistance (ELA) provision of the European Central Bank. This was before we became so familiar with the process in Greece.
The Irish banks had lost a combined €100 billion, borrowed largely from other European banks, which would also have incurred great losses had the Irish government not stepped in. You have to remember that this was before Greece and Spain needed assistance, although as Ireland stepped up to the table, the acronym “PIIGS” was coming into vogue; and some of us were writing about the debt problems that plagued Greece and other peripheral countries. The European Union compelled the Irish government to bail out its banks, and so the Central Bank of Ireland took on the debt (via the ELA) of the six main Irish banks that had failed because of the property bubble.
In the “bailout,” Ireland received €67.5 billion (and in addition borrowed another €17.5 billion from its pension and cash accounts), which it pledged with a promissory note to pay back. The public was quite upset, and the government was then overwhelmingly rejected at the polls, in a clear show of sentiment demonstrating that the Irish people did not view that bank debt as something that should be on the public balance sheet.
Government workers had to take large pay and pension cuts and government services were cut, as one of the conditions for getting the money was significant austerity. This was before “austerity” became a bad word in Europe. Meanwhile, unemployment rose from 4% to 14%.
I visited Ireland after the new government took over. I met with some two dozen business leaders, politicians of all persuasions, journalists, and economists. I remarked at the time that the only thing they agreed upon was that Ireland would never pay that bailout money back. A former prime minister told me that they would not have to openly repudiate the debt, but rather were expecting, after Greece and other countries were allowed to default, to be invited not to pay it.
A leading Irish economist who was at the negotiating table told me point-blank that the IMF negotiator told them they would not have to pay it back. But you have to remember that at the time there was true panic and no road map for dealing with such a crisis. Something had to be done. That something was the issuance of bailout funds (which conveniently minimized losses at said German, French, and British banks), which came with a private assurance to Irish leaders that whatever was done for other countries would be available to them as well. “But please, just work with us right now?”
So the Irish, as we say in Texas, took one for the European team. The blow left a rather ugly scar, as the national debt ballooned into impossible-to-manage territory, crippling the national government.
But there was one group in Ireland that was aghast – horrified – at the idea of not paying back that debt: those were the people I met at the Central Bank of Ireland. And they did have a point. The document that created the European Central Bank did not allow a national central bank to not pay its debts. Governments could default (as we learned with Greece), but not national central banks. Those were the rules that everyone who adopted the euro played by.
At the time, I wrote that the Irish would not pay that debt. I had listened to the 99% of the people who told me so. Silly me. Yet, the last two weeks have seen the Irish convert their promissory note into government debt and agree to sell bonds. So it looks like the Irish will pay after all. Except that when you read the details, the Irish (after a great deal of controversy ensues) will end up either not actually paying or not paying anything close to the value of what they borrowed. So how can they both pay and not pay? That is the topic for this week’s letter; and an instructive reading it is, not for what it tells us about Ireland but for what it tells us about the EU, the eurozone, and the future of the euro.
Who’s Got the Map?
Fans of British comedy will recall fondly the early-‘80s series Blackadder, originally about a self-serving courtier of Queen Elizabeth (played by Rowan Atkinson, who later became known in the US for his role as Mr. Bean). At one point, Blackadder is compelled to sail around the Cape of Good Hope in order to remain in the Queen’s good graces. The voyage seems, of course, like a death sentence, and Blackadder never intends to sail. His nemesis, Lord Melchett, offers him a map and voices the lines quoted at the beginning of this letter. The map is a blank page. “It’s a map of the area that you’ll be traversing. They’ll be very grateful if you could just fill it in as you go along. Bye-bye.”
The document that created the eurozone is right along the same lines. Everyone thought they knew what it meant, or at least the Germans did. The Bundesbank (the German central bank) was quite sure that it prevented monetization of debt. It said so right there in Article 123. But the EU and the ECB (with their faithful companion the IMF) seem to be constantly wandering off into uncharted territory. Banking, credit, and sovereign debt crises seem to require legal maneuvering that was not explicitly detailed in advance. As the rest of Europe looks on, the ECB draws in lines on the map as it goes along.
Article 123, as every good Bundesbank member will tell you, explicitly says there will be no debt monetization. But it turns out that while everyone agrees that monetization of national debts is a bad thing, the definition of monetization is not as clear to much of the rest of Europe as it is to the good German burghers.
Wolfgang Münchau writes rather merrily about the recent “rescheduling” of Irish debt:
Everybody seemed to be talking about monetary financing of debt last week – the ultimate taboo in monetary policy. And hidden behind a veil of unbelievable complexity, the eurozone may have done just that.
Various European central bankers rushed to proclaim that the agreed rescheduling of Ireland’s so-called promissory notes would not set a precedent for sovereign debt laundering. In legal terms, the agreement is probably watertight. It may be a borderline issue, but who cares? In economic terms, the situation is much clearer. This is monetary financing in all but name – and a jolly good thing it is too. (The Financial Times).
All this can get quite complicated (trust me). But it essentially boils down to this: Anglo-Irish Bank was bankrupt. The Irish government had to come up with some type of collateral that it could hand to what was in essence a bankruptcy trustee in order to be able to borrow at the ELA (Emergency Liquidity Assistance, sometimes referred to as “Lending Assistance”). The government gave the trustee a promissory note that was supposed to be paid off rather quickly (in ten years). It quickly became a large financial burden for Ireland’s government – and a very sticky political problem. Only an Irish central banker could love that debt.
But someone in Ireland came up with a very creative solution. They turned that 10-year note into 25- to 40-year bonds. The interest that the government pays on the bonds to the Central Bank of Ireland goes right back to the government. Münchau is right: this is monetization in all but name. But there is a small fig leaf that keeps it from being outright monetization: the CBI agreed to sell the bonds into the marketplace over time, as the situation dictates. From the Irish Department of Finance press release:
The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.).
Let’s put that in context. Ireland issued €2.5 billion in 5-year bonds last month, which are now yielding 2.8%, less than Italy’s corresponding bonds. That is also less than the 5.9% the Irish paid last summer when they first came back to the market. (Someone made a rather large profit on those bonds!) The bank deal has evidently reduced the cost of Irish bonds for the government. They expect to raise about €10 billion this year. Right now, issuing another €0.5 billion in bonds is rather easy for them. Granted, the government has to pay the interest to what will be private bond holders, but that is far less than they were paying.
By switching to lower-interest-rate bonds and stretching out the burden of repayments over four decades, Ireland will save itself €20 billion ($26.78 billion) over the next decade and free up €1 billion for future budgets. Goodbody Chief Economist Dermot O’Leary was kind enough to send me a private client letter that shows what a large help this move will be to the Irish government. It gives them a much better chance to actually reduce their deficit to a European-standard 3% within the agreed-upon 2015 time frame. O’Leary thinks they will do even better.
The Irish ran their plan by the ECB staff before they announced this. I was told that initially they did not offer a specific schedule for selling the bonds, but the ECB (the Germans?) required at least a token schedule.
So, the Irish will pay those bonds back. Kind of. Perhaps.
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