September 20, 2010
Let’s cut to the chase. Ireland is on a slippery slope.
The awfulness of this vista is now slowly beginning to dawn on people.
At first we denied it, then we began to feel that something was wrong, but the penny has finally dropped in recent days. Irish bond yields are moving toward 7 per cent – and this is with the ECB buying government debt as the creditor of last resort.
A Greek-style debt vortex is opening before us.
The way this will end is quite straightforward: money will start leaving the country.
Can it be long before depositors start to get nervous about keeping their money in crippled Irish banks?
They will simply run out of reasons to believe a government that has been wrong about everything and has destroyed the economy.
In reality, a major outflow of deposits can trigger a serious crisis, but it doesn’t mean Irish deposits will not be honoured.
The European Central Bank will not countenance any loss to depositors, but this will not be enough to stop a steady drip-drip of cash out of Ireland.
By the way, there is nothing radical about this contention; this is how these types of financial crises usually end: capital takes flight.
In the same sense as the crash in house prices was eminently predictable as early as 2003, the great Irish flight of capital is equally foreseeable.
Here is how it is likely to happen.
The chronology might not be 100 per cent accurate, but it could play out something like this.
In the last few days, the financial markets have signalled that the bond market is becoming increasingly wary of lending to Ireland.
Yields have now shot up as the foreign investors which lend to us realise that the numbers are not going to add up.
We simply do not have enough cash to pay for the banks and keep the welfare state going at the same time.
This is because our revenue take has practically halved in three years. Investors also realise that there is a limit to which the government can tax the people before the people say ‘‘enough’’. Equally, the markets know that, the more you tax the people, the more the economy contracts.
Typically, when foreign investors give up on a government and refuse to buy the bonds of a country, the government turns to the local savers for frantic final funds.
The government is faced with the choice of going bust and not being able to pay the teacher or squeezing a final few hundred million out of the saving middle classes.
In other countries which have faced our type of crises, the state forced local pension funds to buy government bonds or else froze savings, reintroduced capital controls and tried to grab people’s savings.
Remember, savings are very easy to get at.
A ‘temporary’ new Dirt-style tax must look very attractive to tax collectors.
The background noise to such a move will be, first, a flight of capital from corporates which are no longer prepared to keep their money in local banks.
They are not being paid for the risk they feel they are taking.
The wrecked local banks can’t pay more interest than healthier foreign banks because the banks are facing a massive funding squeeze. So if a local bank begins to try to raise interest rates in order to attract new – or keep existing – deposits, people will know that that bank is running out of money. Such a move on deposit rates is a sign of panic, rather than confidence.
Contrast this interpretation of a deposit war with the interpretation that pertained in the boom: when a bank offered higher interest rates back then, it was seen to be a confident market leader in the battle for funding.
Today, it would look like a ponzi scheme operator.
So big deposits will fly out the door. At the same time as the corporate depositors change tack, a different conversation is going on in kitchens up and down the country.
Up until this point, the average working person – with a job – had reacted to the crisis by increasing his or her savings.
As the crisis became more severe and taxes and unemployment rose, people with jobs saved more.
This had the effect of contracting demand and, in the process, contracting the tax take.
This is the polar opposite to what happened in the boom. In the boom, we spent, this increased the tax take and the government’s budget balance went into surplus.
Now, we are saving, the tax take is falling, spending rising and the government’s budget position has ballooned out of control.
Now the average person with savings is worried that the state – which refuses to tax other wealth – will tax savings.
Equally, they are starting to realise that, if the government doesn’t have the cash to plug the hole in the banks, then the small depositors will be the last to find out what is going on.
As we have said earlier, depositors will surely be protected. But some may start to move cash out of the country, just in case.
All the while, the financial markets and financial press are looking at the country and, despite the assurances of the ECB, they see the dilemma faced by us, which is that our balance sheet is ruined.
On the asset side of the national balance sheet is property, which has collapsed in value.
On the liability side of the national balance sheet is debt.
Unlike property values, the debts have not fallen. In fact, the cost of the debt is rising because the rate of interest on the debt is rising at a rate of at least 6.4 per cent per year.
Taken together, it is easy to see that Ireland has run itself up a financial cul-de sac.
The only way out is to bring forward the crisis, rather than wait for it.
We can do this by forcing a debt-equity swap in all the banks, thus significantly reducing the cost of the bank bailout.
AIB needs to be the bank that the government focuses most on, as it is our biggest bank and still faces significant hurdles.
Regarding Anglo, we should tell the ECB and the Irish Central Bank – the two biggest creditors – that the game is up and they will have to take a huge discount on their ‘investment’ in Anglo. As for the subordinated bondholders, they should be told where to go and the other bondholders should be given the number of the liquidator.
If we don’t face the crisis head on, the next few months will witness capital flight and the crisis will come to a head anyway. Better to get on with it.