Tag Archives: ELA

Germany’s Dilemma – Sacrifice Cyprus or Make Sacrifices Itself…

dino_2010_12_10_martirio_marcantonio_bragadinThis is an updated and linked version of a column published in The Irish Examiner Saturday 24 March 2013.The deposit tax debacle in Cyprus is rich in historical resonances as well as showing that frankly as Leigh Phillips suggests in the EUobserver Europe is run by the three stooges. Skinning the Cypriots is not new. In 1571 in the height of the venetian ottoman war the defenders of Famagusta stood staunchly against the ottomans. On surrendering the leader was, despite promises of safe passage, skinned alive. Now we see that despite promises to “do whatever it takes” the ECB has supported skinning cypriot deposits. How doing whatever it takes squares with destroying trust in banking, bullying small nations and serially upping the ante is beyond me. Its even  almost beyond Karl Whelan.

hacha_emilEurope seems unable to work in a sensible manner, and is devolving into a crisis junkie. Again we see a meeting at 3am making decisions that in a fog of fatigue may have seemed sensible but on waking perhaps less so. The historical ironies pile up and people make mistakes.  Cyprus is a small nation, far away. In 1939 a hegemonic Germany called the president of the independent rump of Czechoslovakia to a meeting. Hacha though the meeting was going to be bad but was subjected to a grilling and a haranguing that resulted in his collapse and the death of his country. What we saw in the meetings last week was, I would argue, little different. No, Im not suggesting that the Troika are Nazis. I am suggesting that big countries and their acolytes tend to have modes of operation that can be hidden for decades and then, to everyones surprise, come back to the fore. While not suggesting that anyone is going to invade the 60% of Cyprus not under occupation, the reports of the Eurogroup meeting are frankly nauseating. A hegemonic Germany, its allies and with the silent acquiescence of the rest of europe  placed unreasonable demands on a small country. But we have seen this time and again and not just in the 1930s. If this is to be a union then it must be a union of equals. Even in the USA the bigger states cannot dictate to the smaller, save via the federal system.

imagesThe historical ironies mount up. A century ago nobody really wanted a pan european war (At least not in 1914) and yet we found ourselves at war through a combination of poor diplomacy, overreaction to minor events, and a rigid adherence to plans laid in different times.  Even as late as the start of the war Kaiser Wilhelm wanted to call it off to be told that the ReichBahn couldnt alter its plans and the trains were rolling. I dont know if Germany wants to kill the Cypriot model, although it has made it clear that they see it as dead. I do know that this approach, of frankly bullying and using the golden rule in its most naked form, is neither in the political or economic interest of the union. If you think that I am alone consider the views of Christopher Mahoney, who argues that the approach being taken will result in a latin american style EU. We may yet (although I do not think so) see Cyprus leaving the euro, and showing that that is possible, from a combination of these same factors. We have learned nothing in a century – neither how to live with a strong Germany nor how to contain a rampant Germany.  There is an excellent article on the new German problem in The New Statesman.

Kipper Williams on CyprusThe genie is now out of the bottle with regard to depositors. Just this week and under the radar Spain introduced a deposit tax. Yes, it will be small (for now) and yes it will be paid by the banks (of course they wont pass it onto the customers…of course) but there it is. Commerzbank have mused on  deposit tax for Italy. Deposits, including guaranteed deposits, are now in the firing line and we should all be wary and aware of that.El-Arian of PIMCO compared this to “lighting dynamite”, and he is right. Again go back to Mahoney of Moodys, linked above. He notes that we are now seeing the rise of “non convertible euros”, something unique. And why? for a few billon euro. Never has so much been at stake for so little.

748203817-1 There are good arguments for bailing in creditors of failing banks, depositors  at some stages included. What there are not good reasons for is crashing an entire economy or for destroying fundamental trust. Even with capital controls, Cyprus is in for a massive crash. .  Simple economics (remember them?) remind us that MV=PY. M is money, V is how quickly it moves around, P is the price level and Y is income. This isn’t a model it is not a forecast its an accounting identity. With M in Cyprus going to fall like a stone then either money works harder, the price level falls (deflation, more destructive than inflation arguably) or the income level falls. Most probably all will happen but given prices tend to be downwardly sticky I suspect the majority of the adjustment will come on the level of national income. Estimates from market sources are for a 20% drop, and this is supposed to be the good outcome? Even with capital controls in place, and In passing we might wonder how exactly we can build a union built on free movement of goods, capital and people with capital controls, who now will trust cypriot banks? You dont have to be a wild eurosceptic to think that the introduction of capital controls is the death knell of the euro. There is an excellent blog on this issue in the Telegraph. Imagine capital control in say Warwickshire viz a viz the rest of the UK, Vermont versus the USA, Leitrim versus the rest of Ireland. Thats what we are now proposing.

images-1The proposal now (friday morning) on the table is to save guaranteed deposits and move unguaranteed (those over 100k) into a bad bank where they might end up getting only 40-50% return. There will also be a sovereign solidarity fund and some gas bonds. While few will grieve for oligarchs losing money lets sit back. companies, charities, people with money saved prudently and legally, anyone who is in the middle of a transactions chain with cash at the moment will also be cut. This will hit prudent cypriots and Cypriot SMEs hard. It might well hit some oligarchs but to be honest they will have their money stored in yachts in Monaco and Belgravian mansions not on deposit in Laki bank. The Russians that will be hit are those middle class savers who have done well from the last two decades and who, legally or no, saved that money in Cyprus to reduce the chance of expropriation. Sure, some mafiosi will be cut but are we now adopting collective punishment?

a_grouchy_german_is_a_sour_kraut_mesh_hats-p148042438037453225enxqa_400Cyprus has been sacrificed on bad grounds. Its banks are overly large (although not as large as some other EU countries as % GDP) and the business model was flawed. But they were holed below the waterline with greek bond cuts and the collapse of the greek economy.They asked repeatedly over the last 9 months for assistance and when it came it was too late and flawed.  The unwillingness of the europeans to consider flexibility in how to deal not with a bank but a banking system that was imploding is dogmatism at its worst. There are alternative plans out there that will deflate the cypriot banking sector without crashing the economy. But none of them seem to satisfy what is increasingly looking like a teutonic desire for exemplary punishment “die andere zu ermutigen” as it were….Every time a proposal emerges for sensible enhancement of the crisis management capacity of the eurozone so too will some obscure german to explain why the voters in lower thuringia won’t like it. The banking union, the existence of which might have saved this from being a quasi existential crisis, is stalled, on the rocks of German intransigence and unwillingness to realise that they are the leaders and that that involves leading. And sometimes to lead is to incur costs.  Germany is not the eurozone and its time that this was made clear by the others.  Either they pull their weight, and yes that may mean some costs somewhere down the line, or the eurozone staggers on at best with a lost generation at worst towards a breakup that will cost Germany anyhow. Forget Cyprus – Germany is the real problem state in Europe right now. Brendan Simms posits it well in his New Statesman article

The question we face now is this: how can the Federal Republic, which is prosperous and secure as never before, be persuaded to take the political initiative and make the necessary economic sacrifices to complete the work of European unity?

Over to you Germany….

IBEC and IBRC and the IMF

This is a version of a column published in the Irish Examiner

It must be dangerous to be a bird in Dublin these days. The government that promised transparency has instead adopted a kite-flying approach. The kites pop up, and like modern day Benjamin Franklins the government minister hangs on as it drifts into the storm, and then gauges the lightening. Occasionally they get singed, sometimes they escape, and withdraw for another day. And its not just the government. Every other aspect of social partnership is busy with economic bals and fiscal paper and silk, constructing and testing kites. In the best Japanese tradition, and as we are heading towards a Japanese style lost decade why not, we even see kite wars. Some kites are saw edged and designed to cut down others. Some kites get smashed down and then amended get relaunched.

 

IBEC have joined in this pleasant pastime recently, with their proposal that public sector increments be paused. The saving from this would be approximately 1b per annum it appears. The problem with such increments is that they are generally paid regardless – one is on a salary scale along which one advances by dint of survival. In a modern managerial environment that doesn’t make a lot of sense – there is little incentive to excel, and little disincentive to slack. Of course, we have know this for decades and for a long time it suited IBEC as a member of social partnership to allow this to go on. Peace at any price was the seeming mantra. Cutting a billion euro from the state budget is eminently justifiable in the context of borrowing a billion. However, throughout the crisis the argument on cutting public sector wages has been notable for a lamentable lack of follow on argument. Cutting X does not save X. At the most basic it saves less than X due to the fact that yes, public sector wages are subject to tax. So 0.7X might be the after tax savings. And then there is the knock-on effect…

 

we have seen recent estimation from the IMF of these effects. In economics the effect of changing one item on another is known as a multiplier. The assumed and conventional multiplier for government expenditure was in the region of 0.5-0.7. This would imply that cutting X would in the end result in a fall in overall economic output of 0.5 – 0.7X. In other words, cutting wages would not have the overall effect of reducing the economic cake by the same amount as the wage cut. This may now need to be revisited in the light of the IMF world economic outlook report which suggested that far from being less than 1 (implying that cutting public sector pay would result in a small fall in output) these shortterm multipliers may be significantly greater than 1. In other words, cutting X will result in a decline of 1.5 X– 1.9X .

 

Whatever the attraction from a government accounting perspective of cutting the short and medium term effects on the rest of the economy would be significant and negative. In the Irish case the effects are complicated by the GNP/GDP issue – while GDP can be growing or contracting slowly the GNP component can be falling more rapidly. Thus we cannot say with confidence that based on the IMF analysis the multiplier is too small we can take it that some very significant work on same needs to be done, pronto, by a combined ESRI-DFinance-C Bank team to ascertain the best evidence. In that context, we might want to hold fire on accelerating the pace of consolidation

 

IBEC have not, to my knowledge, come up with a comprehensive set of implementable performance metrics – that to be fair is not their job – but one must applaud their desire to save a billion. However, why stop at a billion? Why not save three times that much, and harm nobody? Part of the problem with cutting government expenditure is that it gets recycled into the economy. It is rare to have government expenditure which is totally isolated from the economy, and yet we have such.

Each year the government spends 3.1b feeding the IBRC (anglo/inbs) black hole. This year in a cunning plan instead of real money they issued a bond to the beast. The borrowed or tax derived money, you will recall, is given to the Central Bank of Ireland who then destroy it. As far as I can ascertain IBEC have not expressed concern about that, except in so far as the technicalities of the bond v cash 2012 payment impacted on government aggregates. It is abundantly clear that there is little appetite in the ECB for a deal on this money. At the very best we might replace this promissory note (which is not government debt) with a 40y bond. At worst we will be stuck with the full repayment schedule. It would cause nothing but the closure of IBRC and a technical temporary accounting headache for the Central Bank if the government were to announce that in framing the 2013 budget they were not going to make the March 2013 (or any subsequent payment). The ECB would be unhappy but I guess we can live with that. What they would not be able to do is to “cut us off” from liquidity. It would be nice if IBEC were to advocate saving 3.1b but then again IBRC is a member firm of IBEC. This money does not get spent in the Irish or European economies. It vanishes. We borrow it, and we destroy it. Why not…not borrow it.?

 

The Quantum Mechanics of Irish Debt


This is an extended version of a column published in the irish examiner. The Irish government find themselves on the horns of a dilemma. They, quite properly, seek a write down, from somebody, anybody, of a large part of the banking debt, which has accumulated. At the same time they wish to convince the markets that everything is ticketyboo and, and that any day now we will return to normal funding of the ongoing government deficits via the private debt markets. These two issues cannot be reconciled. What the government are saying is in fact the Irish debt is Schrödinger’s debt. It is both sustainable and unsustainable. In this thought experiment we the people who pay the debts are left in the dark. Economically, we are Wigner’s Friends. It is manageable debt if you are trying to persuade bond investors to buy into the idea that having failed over decades to run the country as a a going concern we have now mended the error of our ways and will be prudent. It is unsustainable if you are in talks with Troika officials and you need them to persuade their government that we are at the brink of penury and revolution. That these meetings take place in a peaceful prosperous country where nary a revolt is on the horizon is unfortunate…

In June of this year the government announced to great fanfare that a decision had been taken, in principle, which would greatly alleviate the Irish debt position. This was, we were told, “seismic”. It came from the 29 June meeting where the phrase “similar cases will be treated equally” was used in relation to ESM dealing with Bank debt. Thus far the evidence is that if it has been a seismic experience It is more an event of Richter scale 2 than of Richter scale of 10. The earthquake off Mayo in early June was scale 4, and nobody really noticed.

Throughout the summer it has been clear that the event that preoccupies the European government is when, rather than if, Spain will be forced into seeking a bailout. As the fourth-largest economy in the Eurozone it is too big to ignore. We on the other hand can be very safely ignored. We have shown over the last four years that we are perfectly willing to acquiesce to every requirement that emanates from the center of Europe, no matter how deleterious this may be to the long-term health of the Irish economy. The Irish negotiating position has been to lie around with a pathetic look on its face hoping someone will take pity on us while we continue to annoy them with various quaint local customs such as having a low rate of corporation tax, paying ourselves over the Euro area median salaries in all sectors, and generally not being good germanofinns.

I have characterized this numerous times as sending out nice well meaning Irish fellas to negotiate with the heirs of Bismarck (who suggested swapping the Irish and Dutch populations, enabling the Dutch to feed the world while we would drown in short order) and Richelieu. Throw in the Finns, a dour doughty lot who don’t back down (they took on the Red army in 1939 and beat them to a standstill, with the world record sniper being Finnish with over 500 confirmed kills) and we are hopelessly outclassed.

At the end of 2012 the national treasury management agency estimated that our national debt will stand at €187 billion. This is 117% of GDP, Just behind Greece and Italy/Potugal. If we accept that there is a large chunk of GDP, which cannot easily be taxed, then the appropriate metric becomes GNP, and the figure then makes Ireland look much closer to Greece than it does to Italy. Of course, the wedge between GDP and GNP is one that we have allowed to grow as a consequence of our reliance on high money low job FDI, and that policy choice of acting as a tax arbitrage location is one that is hard to explain as being a core tenet of economic growth to a German, a Finn or a Dutch official or minister. And lets not even go near the French…

Of our debt two thirds has been accumulated in the old-fashioned budget deficit way. While the debt exploded after 2009 this is not all bank debt. A large part is down to the hole in government spending that had opened up through overreliance on bubble taxes. And it will have to be paid down in the old fashioned way – by reducing spending and increasing taxes. Indeed the deputy governor of the central bank has gone so far as to suggest that we run surpluses to pay down the nominal debt rather than letting it erode through time and inflation. He doesn’t see growth roaring ahead. How this will happen is unclear as every single special interest group are NIMPPs – Not In My Pay Packet. Absent a banking debt mountain we still have a problem. That said, the willing lunacy of the bank guarantee and the Anglo bailout tipped the country from a fiscal problem to a fiscal basket case.

We have poured in in excess of €60 billion into the banking system. We have put in approximately €20 billion into the main banks, which equity is now valued at approximately €8b. The statements recently from Finland , Austria, Netherlands and Germany (FANGs we may call them) makes it very clear that the creditor nations are willing to contemplate the GSM only taking further equity stakes. In other words legacy bank debt is not going to be on the table. We are therefore stuck with this ownership, stuck with the money sunk into the banks, and unlikely to see a rapid return on this money. The largest part of the banking debt that can be put into play relates to the IBRC promissory notes. Every year, on 31 March, the Irish government pay €3.1 billion to IBRC, who pay this onto the central bank, Which then destroys the money . I have consistently been of the opinion that this is political, economic, and indeed in the context of swinging budget adjustments moral lunacy. Successive Irish governments have taken the approach of Mr Micawber, that something will turn up, in relation to this Schrödinger’s debt. Something has turned up, but it’s not a something to our liking. At very best it is likely that this promissory note (which is not government debt, as if it were a government debt then Anglo could have gone to the European Central bank and obtained liquidity rather than having to go through the Irish Central bank) will be replaced by longer dated government debt. This will reduce the annual outflow, but will not reduce the stock of debt. A year ago I suggested that on the return of the Dail the Taoiseach should have stated that we were no longer going to pay this debt. I stand by this. If the Irish government were to tear up the promissory note, is my view that nothing will happen. At least, nothing bad will happen. Both Anglo Irish bank and Irish nationwide building society would become immediately insolvent. This would then force them to be wound up. The central bank of Ireland would either have to sue the government for the repayment of the promissory note or have to accept the loss of it. The consequence of this would be that the €30 billion would remain as created money.

The argument against tearing up the promissory note runs that upon this happening the ECB would cut off all funding to Irish banks. The latest data suggest approximately €60 billion in ECB funding is made available to the Irish covered banks, and some €80 billion to all credit institutions in Ireland. This argument is bunkum. What the ECB would be doing in that context would be punishing a well performing (within the troika program) peripheral country for taking immediate steps to ensure that its sovereign debt is sustainable. It would become clear that no matter what their government did it would not satisfy the monetary uber-Hawks of Frankfurt. It would crystallize the fear that many on the periphery of Europe have, that in the eyes of the core (in reality in the eyes of a toxic blend of populist politicians and frightened faceless bankers in thrall to the ghost of a memory of a supposed consequence of a monetary event in the 1920s) the periphery is dammed if it does and dammed if it doesn’t. I do not believe that the ECB is a suicide cult, which is what it would have to be if it were to in effect force Ireland out of the euro. That is what logical endpoint of cutting off liquidity would be, and no organization willingly engages in an action which will result in its own demise. .

Euro deal saves Ireland? Maybe…

It’s not clear that it does. I’m not sure it’s a seismic (Enda Kenny) or massive (Eamonn Gilmore) deal. And it happened because of Spanish and Italian pressure.

So far as we can see at present there are three parts to this. The Spanish banks will be recapped directly from the EFSF and later the ESM (assuming there is one…) which will not have formal super senior status but will be more like the IMF and have quasi senior status. The ECB will get an enhanced supervisory role. Crucially for Ireland the deal also suggests that similar cases will be treated similarly. But there is no explicit retrospection.

We have spent, in very rough terms, 30b on Anglo promissory notes, 20b from the then National Pension Reserve Fund in direct bank recaps and about 12-14b more in other recaps, bailouts etc which forms part of the explicit borrowing now subsumed under the troika bailout..

We will not get that 20b back. It’s gone. We might, but it’s not clear, get a deal on the prom notes, but the mood music is that at best this quasi state debt will be converted to very much state debt albeit repayable in a manner that costs less per annum than the 3b cost of prom note redemption. We might or might not get a deal on the 12b, but there is no “Irish state bond for recapping banks” out that can be redeemed. So this would have to be dealt with as part of a general state debt not bank debt deal, which seems not to be o n the cards.

It’s a soda stream not a champagne moment.

The Fiscal Compact, LTRO and sovereign debt

This post is a longer version of an oped published in the Irish Examiner Saturday 3 March 2012

So, another European referendum looms, with all that heat and lack of light that we can expect based on previous referenda. Expect the arguments from the no side over the months ahead, to revolve around septic tanks, water charges, local hospitals, waste collection policy, calls for imaginary non-austerity policies, anything but the substantive issue. This will be matched on the yes side by increasingly every more apocalyptic warnings of a no, stating the dangers of being expelled from the euro, the EU, EFTA, the UN, the planet, with accompanying rains of frogs. The reality is that the fiscal compact, as I have noted prior, is a poorly specified and blunt instrument to institutionalize euro wide a particular style of Germanic fiscal policies. It may however be the best poor and blunt instrument we can get at this stage. Many questions remain, and I await answers to them as a voter.

To reiterate, the core of the compact is that countries should adhere to a 60% debt/GDP limit, getting there via a deficit target of 3%, and a structural deficit of 1% per annum.

The present state of Euro affairs is that for the most part countries are outside these limits. For 2011, looking at the Eurozone, Estonia, Finland, Luxembourg, Slovakia, and Slovenia are at or below the 60% limit and only the first three comply with all the requirements. Outside the zone only Sweden is compliant. Thus the entire EU is being asked to adhere to a rule that at present less than 4% of the union, by GDP, can achieve. This is strange to put it mildly.

The good idea at the heart of the Fiscal Compact is that in the long-term a lower debt/gdp ratio is more sustainable, the country is more solvent. The 60% level is well below the by now generally accepted 80% as being danger and 120% unsustainable rubrics which research has indicated. Thus, the fiscal compact is one of good intentions. My concern is whether we can in fact get from here to there. For many of the highly indebted countries we are seeing the limits to austerity. The danger of self reinforcing negative feedback loops, where more austerity leads to a faster decline in the economy requiring more austerity to reach targets is evident in Greece and spain and in my and other opinions we in Ireland run that risk also. Indeed, the EU commission has noted this stating

“negative feedback loops between weak sovereign debtors, fragile financial markets and a slowing real economy do not yet appear to have been broken.”

In the Irish case, which is the one we should in the first instance be concerned with, we face two separate but interlinked debt burdens. First, we have a debt burden, the largest part of the total, which is as a consequence of previous overspending by governments. Second, we face a debt burden arising from the disastrous banking policy of 2008-9. Much of the talk on the compact is around whether we can get relief on the 3.1b per annum repayment of the Anglo promissory notes. The Irish times posits this talk as being “a quality of deep naivety or cynical politicking”, a Manichean view that omits the possibility that…one might think it the right and correct thing to do. I have been arguing for years , sometimes in the Irish Times no less, that whatever about the other banks, Anglo (the black sheep of the Irish banking crisis) and INBS (its dingleberry) should not be a drain on the taxpayer. So have many others, including even now the IMF, and it is sad to see a lamentable lack of understanding of the basic elements of the Promissory Notes that once again the Times seems to think that the interest rate on the notes is an important issue. While complex it was not beyond the comprehension of the members of the Oireachtas committee to see that this is not the case. See here for my presentation, here for Karl Whelan and here for Stephen Kinsella.

At present the success of the austerity policy is being noted via the fall in bond yields. While this has happened, it is in significant part down to the trillion euro of cheap three year money which the ECB has made available to banks over the last months vi its Long-term RollOver programme. What has happened to this money is that banks have taken the cash at 1% and either paid down own debt or invested in high yielding peripheral bonds, gaining significant profits either way. The effect has been to restore faith in the bank bonds, again showing the importance that the ECB can play if it desires. Very little of this money has or will trickle down to the real economy. This money is for three years only, as otherwise it would result in a seemingly unacceptable increase in EU money supply.

A proposition then appears which while logical and in my view sensible would almost certainly not be approved by the inflation and austerity hawks of the bundesbank manqué that the ECB has become. It is to explicitly link the writing down of all national debts to 60% GDP via monetization of debt combined with the fiscal compact. At the bottom of the post see a table where I show the present state of debt and how much of a reduction would be required to get it to 60%. If we think that the broad outlines of the fiscal compact are reasonable sensible (and with reservations, I do) then we should ensure that all countries are able to adhere to them. The issue is that we might not be able to get from here to there. So, while as a general principle monetization of the debt leads to inflation (defined recall as too much money chasing too few goods, and it is undoubtedly the case that at present there is a lag in aggregate demand in Europe making the too few goods argument weak), as a once off restoration of state balance sheets along the lines that the LTRO has done for bank balance sheets I would support it. Inflation in the Eurozone is hardly raging out of control.

While Eurosystem central banks are prohibited from directly purchasing government debt the use of LTRO funds via banks has indirectly breached this. But reducing government bond yields is only of use to a country seeking to raise funds if that country is solvent. To reduce the debts of all , even Germany, to the 60% level would require 2.4t to be mobilized, used to purchase and retire debt. We have seen that While this is a very large amount, it would be of direct benefit to the citizens of Europe. If we can, in effect, bail out the banks via the LTRO then we should be willing to bail out the citizens. To do otherwise would be in my opinion immoral.

Debt as % GDP 2010 Debt €M GDP 60% Target Reduction in Debt
Greece

144.9

329,351

227,295

136,377

192,974

Italy

118.4

1,842,826

1,556,441

933,865

908,961

Belgium

96.2

340,739

354,198

212,519

128,220

Ireland

92.5

144,269

155,966

93,580

50,689

Germany

83.2

2,061,795

2,478,119

1,486,871

574,924

France

82.3

1,591,169

1,933,377

1,160,026

431,143

Hungary

81.3

78,250

96,248

57,749

20,501

Austria

71.8

205,576

286,318

171,791

33,785

Malta

69

4,250

6,160

3,696

554

Netherlands

62.9

369,894

588,067

352,840

17,054

Cyprus

61.5

10,653

17,321

10,393

260

Spain

61

641,802

1,052,134

631,281

10,521

total

2,369,586

 

 

Presentation to the Oireachtas Committee on Finance 15Feb2012

Below is a version of the written presentation I circulated to members of the Oireachtas Committee on Finance at our discussions today on ELA and Promissory Notes.

ELA is money. It is not a bond. Dealing with ELA does not involve dealing with bondholder although the money so created was used to redeem (pay off) bondholders. The acronym ELA stands for Extraordinary Liquidity Arrangement, and the name of indicates what it is. It is first and foremost extraordinary, in that it is a facility extended to commercial banks by central banks when ordinary (usually taken to be interbank or regular central bank ) short or medium term funding is not available for whatever reason. It is liquidity, in that it is designed to allow a bank to maintain liquidity to its operations and customers, rather than a solvency arrangement, which is designed to ensure that the organization is well capitalized and able to trade in the longer term. It is a basic tenet of corporate finance that we draw a distinction between these two concepts ; solvency, achieved through capital, is a longterm concept while liquidity is a rolling short-term issue. Liquidity crises, for countries or for companies, can arise when lenders no longer have confidence in the solvency of the borrower. This is what happened in September 2008, the initial focus being on the solvency of Anglo and Irish Nationwide (now collectively known as Irish Bank Resolution Corporation, IBRC).

ELA is money. In the normal course of events in the eurosystem money is created under agreed mechanisms. Central Banks have the power to create money ‘by fiat’ that is to say they can create it from nothing. ELA is not part of the normal operation of this monetary creation but is allowed in extraordinary circumstances. ELA is carried as an asset on the balance sheets of the creating central bank, in the case here the Irish central bank. It is not created by borrowing from other central banks. It is not a bond. It is not money loaned to the central bank of Ireland from the ECB, nor money loaned from the other central banks. It is money, as real as any other form of credit agancy. It is pure money creation, by fiat, allowed in exceptional circumstances. As of end-2011 this domestically created money amounted to some €44billion.

How is this money mobilized? When Anglo/INBS became hopeless and obviously insolvent the Irish government recapitalised them. The largest part of this recapitalisation was via the creation by the irish government of a Promissory Note which was issued to the banks. This was not and is not a sovereign bond. We know that it was not and is not as the ECB refused to accept this for normal liquidity operations, forcing Anglo/INBS to instead go to the central bank of ireland and swap this for money which was then used to finance Anglo/INBS, including paying off senior bondholders, paying staff wages, payment of interest on deposits etc. In effect the Central Bank of Ireland monetized the government IOU. The government have agreed to pay off the Promissory Note over a 15 year period. As there is, to put it mildly, considerable doubt as to whether the remaining assets of IBRC are sufficient to generate income to repay its debts the Minister for Finance in March 2010 as well as creating the Promissory Notes also gave (as of this date secret) letters of comfort to the Central Bank (Sole shareholder, the Minister for Finance) promising repayment of the ELA were IBRC unable to repay. Thus the state in effect is indemnifying itself against its own actions. An analogy might be that we borrow from a bank, put that money into a pocket, then move it to another pocket, then take it out and burn it. The effect is the same. Money is destroyed in the same amount as it was created, in order that the european money supply does not increas

How much is this going to cost us? In essence, through the next 15 years the state will repay the promissory note at a rate of approximately €3.1b per annum.

This repayment is treated in the government accounts as a capital expenditure, and can be found in Note 6 of the 2012 estimates as show above. This expenditure cannot therefore be deployed to other, productive, usage. Each year a capital allocation is made for the repayment of these. This capital must be either raised from taxation or borrowed. The true interest issue therefore of the Promissory Note is NOT the implicit interest rate which is paid on them, rather it is the cost of the funds borrowed to, in effect, recapitalize the banks holding the Promissory Notes. Thus seekingconcessions on the interest rate element of the Promissory Note is seeking the wrong concession.

Another issue as to why this matters and why we are paying is that Eurostat decided that as the Promissory Note was irrevocable it was appropriate to treat this as a €31b increase in the national debt, resulting in a world-beating 32% of GDP deficit in 2010. There is no doubt in my mind that the nature of the note and the consequent realization that it was in fact debt played a large part in the slow but inexorable locking out of Ireland from the regular bond markets and the need to become wards of the Troika.

What can be done about this and who can do it? The essence therefore is as follows: the Central Bank of Ireland has created money, outside the normal course of Eurosystem operations for the creation of money. This it is allowed to do under delegated power. However, this delegated power is circumscribed. In effect the ECB council can veto the action of the national central banks when they act in the manner in which the Central Bank of Ireland has done, but only by a 2/3 majority. Thus the presumption is that in general when central banks act to extend ELA they are doing so in a manner that does not interfere with the normal actions of the ECB.

This is where the crux of the matter lies I submit. While the creation of €40b or so of additional money by the central bank of Ireland is small in the context of a Euro area M3 (broad money supply) of €9800b, amounting less than 1/2 of 1%, the ECB has a mandated inflation fighting role. Add to this the historic antipathy of Germany, the dominant power in european monetary affairs, to any form of inflation and we see that the creation of money in this manner is potentially problematic. Were the Central Bank of Ireland not to require the repayment of the ELA, and the writing down of the money supply, this would represent a permanent increase in the monetary base of the Eurozone. 1/2 of 1% is not much but what if other countries were to commence to refinance their banks in this manner? What if in fact countries were to take up a suggestion made that the debtor countries refinance their sovereign debts in this manner? Ireland issues a €X hundred billion promissory note to IBRC, IBRC swaps that at the Central Bank of Ireland for newly created money, the NTMA issue a €X hundred billion bond for 100 years duration at a low interest rate, and IBRC purchases the bond with the real money which the state now has on hand on deposit to fund itself while we restructure the financial and economic system. What if Greece were to do this? Clearly we could quickly find hundreds of billions of ELA created euros being added. This is what is known as monetising the debt and it is anathema to the ECB for reasons of inflation as well as being a de facto breach of the rule that the ECB is not allowed to finance government deficits directly. Such monetary creation is further anathema to countries such as Germany who have in the past suffered episodes of hyperinflation. I would note that at 3% inflation we are far from hyperinflation. European money supply (M3) has remained within a narrow band of €9.2tri to €9.8tri since the middle of 2008 and in recent months has in fact begun to fall sharply again, having fallen heavily (as might be expected) in the   global financial crisis.  We are a long way from inflationary pressures.

It is highly probable that were countries to seek to do this they would find themselves running a real danger of being cut off from further and ongoing liquidity support, might be accused of having the central banks funding the deficit (deficit financing) and be in breach of treaties. Such a move would only be used in extremis but it does show that ELA has the potential for unlimited monetary creation and should be treated as such. It should be noted that we have had experience of a large currency union breakup in the recent past, with the breakup of the Rouble Zone, which zone lasted after the political union of which it was the currency, the Soviet Union.  . Nonetheless, such debt monetisation while a solution to the immediate liquidity problems of countries would in the long term pose a threat of inflation and would not in any case solve the solvency issues of countries or banks and might in the long term pose more problems than it would solve. However, in the here and now …

There are three ways in which we can deal with the cost of the ELA.

1. One is to extend the term of the ELA repayment from 15 years to a much longer period. Extending by 10 times, to 150 years would reduce the annual cost in the same manner. However, we would be ‘stuck’ with IBRC for potentially that period.

2. Another way we could deal with this cost is to simply write the whole issue off. This is NOT burning bondholders, nor is it burning ourselves. However, the consequence of removing the Promissory Note and associated Letters of Comfort might be to render IBRC technically as opposed to functionally dead. IBRC, if we write off the ELA and the associated Promissory Notes, would have remaining assets (loans not transferred to NAMA) and liabilities (some remaining ELA , some ECB loans, a small amount of deposits and some remaining bonds. If after restructuring the balance sheet IBRC is not able to service its liablities then it can and should be wound up. Again this seems to have been ruled our by successive governments and the ECB over the years, despite that it too would be the effect of saving the state the ongoing drain of €3.1b per annum.

3. A third solution would be to seek to defer, to continue in the kicking of the can at which successive governments and european institutions have excelled. We have already received deferment till 2014 of the implicit interest payment on the Promissory Notes, and if such were to be extended for a number of years the strain would be at least be deferred.

All of these however, of which I prefer the second, would require that the ECB accede to this request. The Irish voice on the ECB is not answerable to either this committee nor any organ of government, which is right and proper. It is in my view highly improbable that Governor Honohan has not raised these or similar proposals at the ECB, but the evidence is that so far there is no will from the ECB to allow movement. Why that is remains unclear as it has recently shown willingness to accept heretofore unpalatable actions in regard to Greece. Removing the burden of the Promissory Notes in some manner would only assist the government. It would assist it politically in terms of implementing the needed closing of the gap between state expenditure and taxation and it would assist in base monetary terms. If the Troika wish to have a ‘good example’ of its policies as opposed to a set of ‘horrible warnings’ they could do worse than quietly monetize the Irish banking debt, making clear that this is (at least in principle) a one off and reflects the reality that in doing so they acknowledge the role the Irish taxpayer has played in preventing contagion into the banking bond market in 2008/9.