December 13, 2010
Last week, we had the tale of two countries.
One country, Iceland, apparently did ‘everything wrong’ by defaulting on its bank debt and increasing government spending as the people of Iceland saved. Iceland told the International Monetary Fund (IMF) to back off until it was ready to do a deal. It also put the bank deal to a referendum.
The other country, Ireland, allegedly did ‘everything right’ by promising to pay everyone every red cent and imposing huge austerity measures on its people.
We handed over the keys to the IMF without even taking a vote on the details of the plan.
When the vote is taken this week, we have already been told we can’t renegotiate any of it, so the next election – from a macroeconomic point of view – is academic.
What is the result of these different paths? Last week, Iceland cut its interest rates to 4 per cent. Its crisis is over.
The deal with the creditors is ready and it will be done in Iceland’s favour. Money is flowing back into Iceland. Unemployment peaked at 8 per cent and is falling. National income is rising robustly again.
Ireland, on the other hand, is getting deeper and deeper into a hole. Last Friday, the Central Bank confirmed what many have suspected for some time now.
There is an ongoing, relentless run on the Irish banks. It hasn’t manifested itself in queues at the ATMs yet, but that’s the way it is going.
In November, the Central Bank said it Injected more than â‚¬10 billion into the Irish banking system. This is to replace the money going the other way: leaving the country.
This brings total Central Bank Support of the Irish banks to â‚¬44.76 billion.
But that’s not all because, when added to the support of the European Central Bank (ECB),a total of â‚¬181 billion is being lent to the Irish banks by the ECB and its vassal on Dame Street.
In medical terms, the Irish banking system – and by extension, the Irish economy – is an anaemic patient losing blood and being kept alive by huge transfusions.
Unless we stop the haemorrhaging, the situation will never stabilise.
The only way that Ireland can stop haemorrhaging is to separate our banks’ debts from our country’s debt.
The reason money is leaving the banks is that the population doesn’t trust the banks; it also doesn’t trust the ability of the government to deal with the crisis.
We realise that Ireland has a debt problem and we also know that the way to deal with too much debt is by having less debt, not more debt.
So the more debt the government takes on, the less credible it becomes and the more we rush to protect our savings by taking them out of the banking system that has proved to be the single greatest destroyer of wealth in this country since Cromwell.
So how do we get to a position of less debt? First, we reiterate that the bank debt is not Irish sovereign debt and it never was; it must be treated as commercial debt.
A commercial default is quite commonplace.
The implication of the ECB’s funding hole in the banks is that they are bust, so they must default or force debt-for-equity swaps, whereby the bondholders and other creditors become shareholders and we move on.
We can only do that with those banks that might survive in the future. As for Anglo, we simply default on it. The debt wasn’t ours to pay in the first place and, secondly, it will simply be a waste of billions of euro, which have to be earned.
Throwing real money into a financial cesspit never made you credible, it made you look stupid.
What’s more, it scared proper investors because they knew, the more money you wasted in Anglo, the less you understood about the value of money and how difficult it was to make the stuff you are so readily squandering.
So what happens when we restructure our debts? Normally after a deal is done, investors flood back into the country.
This has happened in every country where the default was accompanied by a change in the way the country does business.
The most conspicuous examples of this are the US in the 1930s, Brazil in the 2000s, all the Asian tigers in the late 1990s and Mexico in the late 1980s – not to mention all the countries of eastern Europe which defaulted on their debts.
The reason these countries recovered and grew was that they had a mechanism to regain access to markets quickly. It was called the Brady Bond.
I worked in this market for a number of years in the late 1990s and it was the way in which countries that defaulted made their peace with creditors and both the countries and the creditors stayed in the game.
When the emerging-market countries defaulted en masse in the 1980s, the banks – particularly American banks – took huge hits because most of their loans had to be written off.
The market froze until Nicholas Brady, Ronald Reagan’s finance adviser, came up with an ingenious rescue plan.
Brady is an Irish-American. His great grandfather, Anthony Brady, left Ireland, became a friend of Thomas Edison and subsequently made a fortune in the US.
Nicholas Brady had worked in banking for two decades before Reagan appointed him. Brady understood that the American banks needed away to get back into the countries to do business and get some of their money back.
He also understood that the countries needed away out, otherwise they would do business with non American banks and the Americans would have lost everything.
So he came up with a pragmatic deal.
All the old loans were re-examined. Much of the banks’ original principal would be written off and the remainder would be paid by the issue of new 30-year bonds called Brady Bonds.
The new lower principal was guaranteed by the US Treasury.
The countries would have a five year grace period to get back on their feet, but would be allowed to borrow again. Initially, because of the risk associated with former defaulters, the interest on the bonds was high.
However, as the country adopted proper economic policies, the risk fell and consequently so did the interest rate. The price of the bonds would rise accordingly.
Investors bought these new bonds.
This solved the banks’ dilemma because, despite losing huge amounts on their initial loans, at least the books were now clean and the developing world’s debts became someone else’s problem.
The Investors were happy as long as the countries behaved themselves and changed their ways, and the countries were happy because they now had access to new finance.
The Brady Bond solution shows the triumph of common sense over dogma. It is clear that the present strategy of four more years of austerity without any debt forgiveness will not work.
Do you think there is a reason that this policy has never been tried in any other country, anywhere ever?
It’s time to snap out of it and do a deal. Maybe Nicholas Brady – the great grandson of an Irish emigrant – has offered us a workable blueprint.
The Icelanders are certainly better off after following their own path, so why don’t we?
As we are likely to default anyway, why not have a plan up our sleeve for that eventuality?