We cant go back so must go forward…

This post is a slightly expanded version of the OpEd published in the Irish Examiner

Why are Ireland, Spain, the United States, Italy, Portugal all facing financial crisis? All share one similar key characteristic. They all have too much government debt. The Irish debt situation is depressingly simple, with our ratio of government debt/GNP forecast to peak at perhaps 140%.  While most countries the appropriate measure of national wealth is GDN for Ireland, given the very large MNC sector GNP is usually ytaken as being the appropriate metric, and thus a very rough rule of thumb is to adjust ratios by 1/6 to 1/4 when using GNP.

Source : EU Forecasts

A very large proportion of this, perhaps as much as a third, is as a consequence of the government decision to underwrite the Irish banking system, with of course the remainder being the overspending that successive Irish governments have engaged in in order to by and large placate political interest groups. The Italian, French, Belgian, Portuguese, Greek and other debt problems all differ in their origins. .  What is certain however is that financial markets, after the 2007-2008 financial crisis are both significantly more averse to taking on risk and, having in the most part been spared the consequences of the foolish lending by governments pouring taxpayers money into backstopping their losses have a not unwarranted sense that they rather than governments are in the driving seat

There is no doubt that we have the Irish state requiring major fiscal surgery. This will be deep, painful, long lasting and  necessary. Even without any bank guarantee, even had we had the hoped for but in retrospect never likely soft landing from the credit boom we were on an unsustainable fiscal path and would have to undertake the treatment.  We are still spending far more than we take in as a state, and there are no quick fixes. We are only on track for a deficit of 3% by 2015, not an elimination of it never mind a primary surplus which would allow us to repay the outstanding debt

and we face a situation where 20-25% of all tax will be devoted to interest payments on the national debt.

Source for the above : Stability pact update

A large part of the problem here and in other countries is that in the aftermath of credit booms the deleveraging and debt repayments act as a drag on economic growth for perhaps decades to come. As a consequence, markets simply do not see it as credible that selected euro zone countries will be able to easily, if at all, repay the money that they have borrowed. As countries issue new bonds they find the cost of these rises. This of course exacerbates the problem of repayment, leading to nasty debt dynamics. Although there is no magic threshold, much research suggests that over about 90% debt/gap ratios countries can face a spiral whereby the cost of debt service rises at a level faster than the government can find free resources to service it. Note that although it is often stated as being about economic growth this is not quite the case. Even without growth, as we are, governments can find extra resources via increased taxes, greater efficiencies in usage of public funds, and reduced levels of spending. However, this itself is ultimately only a partial solution as this deflation will itself have to come to an end at some stage, if not through economic then more likely through political pressure.

All of this puts huge strain on the Euro, as were a country to be unable to finance itself it would default and/or face massive and rapid economic collapse, which would in turn cast doubt not only on the euro currency but as a consequence of any precipitate collapse, especially in a state such as Italy, on the entire European experiment.

What then can be done? First, we must realize that there is no practical way to reverse the introduction of the euro. We can and should improve its consequences and its operations but the omelet cannot be unscrambled. Those that sell simplistic solutions along this line know that this is so. The merest hint that a government would consider this would result in the flight of all money capable of moving out of every deposit and savings institution. As such a leaving of the euro would only be achievable were the state to in effect leave the European economic area, confiscate for rebranding all cash, introduce electronic and physical barriers to movement of people and money, and cast itself into economic oblivion. There is also the not inconsiderable fact that the Euro, and indeed the entire European experiment, is political, and political between France and Germany. There are literally decades of political capital invested in these countries in the euro and such capital is not lightly discarded.

If we do not have a breakup then what will we see? The polar opposite of a breakup is a fiscal union, where in effect countries become (fiscal) subunits of a larger union, much as leitrim is to Ireland or wales to the UK. Funds including taxes would be raised and spending decisions made at the center, with the recipients being able to at most have some influence on how they were spent at the margin. This, to many countries, is almost as politically toxic as the breakup scenario.

There are intermediate steps. Under the present arrangements the external, non-tax, funding of Ireland, Portugal and Greece is from the center. We retain some (diminishing) power on how we spend it but it is clear that the government here is very much operational rather than strategic in fiscal terms. The European approach dealing with Ireland/Greece/Portugal is not large enough to take on both Spain and Italy. If these countries find themselves unable to raise funds on the financial markets at a reasonable and sustainable interest rate a longer-term solution will have to be found as these, Italy in particular, are real countries.

The present solution is one whereby the European Central Bank will purchase the bonds of these countries on the open market, driving up the price of these bonds and driving the interest rate down. This however is not sufficient in my view, as its treats the issue they face as being a liquidity crisis when in effect it is a solvency crisis. We in Ireland know the consequences of this, as we spent 18 valuable months dealing with the banks as though it was merely a funding not a solvency issue. The ECB approach does nothing to relieve the burden of interest on Italy or Spain, nor does it do anything much to make these countries grow more rapidly, beyond the implicit threat (much more effective to a small insignificant country such as us than to Italy or Spain) to get ones house in order or face even this facility being cut off.

There is also a democratic issue as the ECB is a monetary not a fiscal institution, has neither a political nor economic mandate to dictate to governments, and is both opaque and unaccountable. Some move towards the center taking more responsibility for raising funds with consequent greater control over how these funds are spent is going to have to come, even though this “eurobond” approach is itself not at all popular in Germany.  At a euro aggregated level the ratio of debt to GDP is a large but manageable 80% or so, and as such the euro zone as a whole can in theory borrow much more cheaply than Ireland or Italy. However, that rate would be more than Germany or Estonia can borrow at. Therefore, any move along the axis towards centralization of fund raising will has a cost of greater oversight and control. And that may not be a bad thing given our history. While I dont think the mortgage situation will be as bad as Morgan Kelly thought in 2010, his conclusion there that we will be dependent on “the kindness of strangers” is very apt.