June 9, 2010
Almost two years ago to the day, on June 22, 2008, this column wrote the following:
“Ireland is now going into the early stages of a classic bad debt cycle. While many are still talking about the credit crunch, the crunch is only a mild forerunner of the greater challenge. When one bad debt begets another, the financial system falls victim to a contagious spread of bad or unpaid debts. This is a bad debt cycle.”
Yesterday this bad debt cycle reached the end game. The eurozone announced a government fund of â‚¬440bn, which will act as a guarantee for sovereign debt issuances by eurozone countries.
Think about this: we have arrived at the illogical position where the eurozone governments are guaranteeing their own debt, before it is even issued. So they don’t trust themselves!
Let’s look at how the bad debt cycle has developed for Ireland since that article was penned 24 months ago.
The Irish banks were lending so much that they ran out of sufficient deposits sometime in 2004 and they needed to find money elsewhere to stuff into the economy. They found it abroad.
As a result, Irish banks have a funding shortfall of â‚¬200bn (difference between loans outstanding and customer deposits). This needs to be funded from international markets.
Karl Whelan over at the excellent Irisheconomy.ie website has figures that say â‚¬73.4bn of this needs to be rolled over in the next four months. This is a huge amount and it is far from clear who will finance this.
Meanwhile back at the banks, the property market crash means they are not getting paid back the money they loaned out. So Irish banks are seen as a large risk to international investors. As a consequence, the banks do not have access to the money markets to roll over their loans.
This sequence of events was clear back in summer 2008 and this was the logic of the guarantee issued in September 2008.
The upside of the guarantee was that it prevented a chaotic run on the banks; the downside back then was always that the Government might be tempted to extend it. My understanding at the time was that if it was introduced it would be introduced with a fixed shelf-life and not be extended. Time will tell on that.
If it is extended, the banks will drag the country down, pure and simple.
The reason the guarantee must be allowed lapse as originally envisaged is that the tactic has now reached the limit of its use. The guarantee was a stopgap to get over the panic in October 2008. In the 20 months since then, the banks have not being able to sort out their funding problems. This means either the banks are unwilling to sort out the problem, which is a damning indictment of their management, or they are unable to, which means they are bust.
Either way, the guarantee was their last chance, and they have blown it. But rather than pay for their incompetence, they have been rewarded by the Government with NAMA, which is nothing more than a bank bailout paid for by the citizen.
Because the banks have not dealt with their funding problem, but have prevaricated, the guarantee has bled into our sovereign debt. Because the markets now think the guarantee will be extended and they see that NAMA has put the actual cost of the banks recklessness on the taxpayer, the markets are worried about whether the State (i.e. you and me) can pay for all this.
The guarantee of the Irish bank debts was always a bluff — it was not a policy. There is no way, either financially (or politically) that Ireland could come good on it if it was ever called on. It was about buying time to sort out the banks, not about giving the banks time to run rings around the State. So now it should be let lapse, because a bad debt cycle only ends in one way, and it’s not pretty.
Ireland, of course does not operate in a vacuum. Debt problems in other EU countries have also meant that sovereign funding costs have risen across the peripheral EU states.
In fact for the EU, the Irish banking problem, which was a critical concern last year, has been superseded by a great eurozone debt crisis. As the Greek crisis unfolded, the whole of the periphery of the EU has experienced a massive credit crunch.
The bad debt cycle has driven the credit crunch and the credit crunch has driven the bad debts. Initially, the lack of credit makes the bad debts worse and then the bad debts themselves exacerbate the credit crunch.
In the end there is only one buyer in town of all this junk, the European Central Bank. So, for the banks that can’t access the markets, the ECB has stepped in to give them finance in the short term.
This might hold for the moment, but it does mean that the fate of Irish banks is well out of Ireland’s hands. If the EU does withdraw its liquidity operations, then the Irish banks will have nowhere left to turn. The ECB is not called the ‘lender of last resort’ for nothing.
Similarly for Ireland, the EU has now set up a SPV under the European Stabilisation Mechanism that will provide funding of up to â‚¬440bn to any state or states in trouble. Of course, this SPV is underwritten (guaranteed) by the same eurozone countries that it has been set up to protect.
So, nearly exactly two years after the opening quote above on bad debt cycles, we are in a position where the ECB is keeping our banks afloat, and the Eurozone countries are keeping each other afloat through mutual guarantees. And the underlying problem, which is the same as the problem 24 months ago, is still there. Too much bad debt.
David McWilliams performs ‘Outsiders’ at the Peacock previewing tonight and running until July 3. www.abbeytheatre.ie