Banking Crisis, Bondholders and the Single Currency Project

When a country finds itself overburdened with debt, the solution – if the debts are denominated in its own currency – is to inflate its way out of the problem. Debt is denominated in nominal terms so inflation reduces the real debt burden. Ireland cannot do this, but the ECB can. It would not do it for Ireland or Greece or Portugal alone but if Spain comes under attack, given its size relative to the European Financial Stability Facility, this option will be forced up the agenda.

What would inflating our way out of the debt entail? It can be seen as a type of orderly default. Assume for the sake of argument that the ECB is the owner of all Irish bank bonds; the Irish taxpayer currently owes these funds to the ECB. The ECB could accept a debt for equity swap, which would mean a substantial haircut, so that it – rather than the Irish taxpayer – now owns the banks. It recapitalises them by printing money and then sells them on. The downside is higher European inflation (it will have to take similar steps all across Europe because many banking debts are in fact to other banks, meaning that many will require recapitalisation) and a higher risk premium on all European debt. The risk premium could be moderated though by a pan-European regulatory system which would tackle one of the design flaws in the entire single-currency project.

The major design flaw was that there was no mechanism to tackle asymmetric (i.e. region-specific) shocks. The US has a huge federal budget which absorbs a major share of such shocks; e.g. if California goes into recession, it pays 25 cents less in federal taxes for each dollar its income drops, and it receives 10 cents more in federal funding. There is no such “fiscal federalism” in Europe (the nearest to it, the Structural Funds programmes, transfer about one cent for every dollar gap in income). Asymmetries prevail however, as is evident in that the business cycle in peripheral countries such as Ireland is out of sync with Germany and the core eurozone countries. This design flaw featured strongly in contributions made by Kevin O’Rourke, myself and others (all of us at the UCD School of Economics at the time) during the Irish national debate on whether to join the single currency. So Spain and Ireland got very much lower interest rates than were appropriate over their respective booms, which fuelled their property bubbles. The problem could have been reduced, though not eliminated, by tight pan-European regulation of the financial system.

These design flaws must be tackled in one way or another if the eurozone is not to stumble from crisis to crisis, though it is doubtful that there is the political will for substantial fiscal federalism. There is no painless way out of the current crisis, but inflating our way out of the debt and coming to grips with the design flaws look to me to be the least painful option.

I try to make these points in a politics programme recorded several days ago and due to be shown on RTE when the EU/IMF announcement is made. They’ll only use snippets so I’ve tried to join up the dots here.

56 replies on “Banking Crisis, Bondholders and the Single Currency Project”

Wasn’t the fiscal weakness dealt with largely by the insistence on keeping debt low except in exceptional circumstances? Any country could deal with a regional shock by borrowing….as long as they weren’t already excessively indebted.

The real problem recently seems to be primarily a lack of financial regulation, not a fiscal problem as such, no?

Another design flaw has recently been revealed by Ms Merkel.
In part, the Euro replaced the old, failed, ERM. The single currency gave less targets for hedge funds to aim at. But, as we know, the uncoordinated national policies that previously gave rise to exchange rate misalignments – the target for exchange rate specultors – didn’t go away.

Policy misalignment had to show up somewhere else, if it couldn’t reveal itself in exchange rate misalignment.

Lo and behold, it’s shown up in the bond markets. And as soon as Ms Merkel says ‘we can devalue bonds’, the whole ERM thing gets reborn, along with its inherent contradictions and instabilities. They have always been there of course, just hidden away like a mad relative.

Now the hedgies just go after sovereign and bank bonds, just as they used to go after the very unstable ERM. Actually, they can have more fun now because they can do it in so many innovative and leveraged ways. Never has so much money been gifted by so many fools to so few mildly intelligent men.

I’m afraid that whatever they do today, we ain’t seen nothing yet.

Frank, RTE will first have to clear your contribution to ensure its appropriate content.

On topic it would seem that a prolongation of the crisis is somewhat in Ireland’s interest as to force a crisis in spain will lead to the above whereas to sign now would be to miss the boat and to paper over the cracks for a few years at our expense.

Another question i have is why the urgency to sign today. From Ireland’s point of view today or next weekend is all the same but the Port. spanish need this. Thats a powerful negotiating tool. Does the govt. have the will to push it?

Right now we need to have John Hume or Michael Martin as immediate caretaker Taoiseach today or we may have a constitutional intervention. This international harrassment stops now. We need elections on January 19th, 2011. We will by then have a picture of this situation. I want Fine Gael and Labour to make a government then and I will help if asked to. I will meet any of the following in the High Court at any time and I will personally litigate on behalf of the varied people of Ireland and my three children. I am naming Sean Quinn. Liam Griffin, Johnny Shea of Piltown, and the ten main debtors to Anglo Irish bank. The unwise ten of the Galway tent in my view who are known but need to be better known. I think Larry Goodman may be in there also. The Foxrock low key man who did not like a recent High Court decision may be in this picture too. Businessmen like these are very hard to deal with until you get them into the productive environment of our determined Courts with the oxygen of good media coverage. The Courts work when a strong Dail is chosen by us and put in place. I have been observing a lot of aggression in my country. It needs to stop. Also I am puzzled by the statement by Mr. Kelly senior on radio Eireann some time back that it would only take about six men to run this country. There is an effort to synthesise a panic that does not exist. We will repay fair borrowing but we need to bring some people who wrongfully think themselves ‘strong forces’ to book. The strong forces in Ireland are the no longer silent majority, many of whom look to the Gospels and the Good Friday agreement. Stop the talks now. We will negotiate from a position of strength in the last week of monday. If you are attempting a coup D’Etat then so be it. U.N. please advise and I would be grateful if Washington could make a statement. ‘Be not overcome by bad choices but overcome bad choices with good choices’, the apostle Paul, Letters to the Romans,

Paul Moran, Sandyford, Dublin

So far as the Germans are concerned QE ist verboten and reform of political governance in member-states might be more effective at avoiding – or at least diminishing – fiscal stupidity and incontinence than excess central, federalised control.

But neither seems to be on the agenda of the Powers-that-be. Chancellor Merkel seems to be determined to bring the bond markets to heel. And, in a sense, she is right and will secure popular support – even if some voters’ savings pots are hit. Allegedly sophisticated investors who can’t assess or price risk deserve all they get.

Good analysis, but will it happen? Only if the deal now agreed to screw us, figure above 5% is being quoted, and hope to avoid Spanish contagion is realised.

We are not out of any wood yet.

I assume that any inflating away of debt would also entail rising interest rates and even more people in Ireland being unable to afford to pay their mortgages?

As for all those people taking pay cuts, especially at the lower end, please don’t do anything to make it even more expensive to just live in Ireland.

@Frank Barry

.. Assume for the sake of argument that the ECB is the owner of all Irish bank bonds.’

In effect, ECB is the owner, but refusing to recognise due to adherence to the domino strategy up to 2013 when their political masters hope to have figured it out; this is an error: the peripheral elastic will snap back with a bang ….. elections will begin to really matter.

We are in the front line of the wrong curve … your plausible and logical policy is way ahead of anything that Angela/Nicolas are considering – Trichet might be a better bet ……… and we see European Power ….

I propose our own currency – ditch the Euro! Could An Post print more postage stamps? I believe this is still classified as legal tender?Anybody? The main problem with reverting to our own currency is the flight of capital that will ensue if word gets out. Did we burn all the old Punts or did we store them with the electronic voting machines? If not we need the IRA to be employed to start the work.
The only other alternative is for Germany, France et al to leave the Euro and set up theit own currency and leave the rest to deflate their way out. We will reconsider any future applications to rejoin the Euro on our terms. PICS can fly!

Should there be a rise in inflation, there will be a rise in interest rates, not driven by the ECB, but driven by the bond market. Because inflation will surely push the bond market to look for higher yields across all durations. If the ECB does not respond, it will be out of step with the main money mechanism.

For inflationary measures to work, inflation expectations have to rise and with them wage demands. Short of a fall in the value of the euro, this would be a serious compeititiveness issue for the eurozone as a whole. Without wage demands, the variable-interest rate economies will be in more trouble as already indebted consumers pay more, with little traction to increase wages.

I don’t think inflation per se is a magic bullet.

However, printing new money to replace bad old assets might not be inflationary?

“Germany, France et al to leave the Euro and set up theit own currency”

Is there any good economic arguments against this idea (as opposed to political arguments) ?

Germany France etc secede from the current Eurozone into a second currency zone (e.g. the “euromark” or something like that ) , while Ireland and Spain remain as they are. The ECB could even run both currencies.

Consider that next year might bring a similar crisis in Spain. How would Europe meet that challenge? A €1 trillion bailout?

“When a country finds itself overburdened with debt, the solution – if the debts are denominated in its own currency – is to inflate its way out of the problem.”

That option wasn’t open to Ireland. But what was the logic behind doing the opposite – and increasing the debt burden via deflation?


the euro has little economic logic behind it. A currency consisting of the PIGS, Malta, Italy, Belgium, Slovenia, Slovakia, Greece and Cyprus would have little logic.

The reality is we joined the Euro to diversify away from dependancy on England & Scotland. It was also conceived that we could put economic policy on auto pilot. In other words our pols and CS could pay themselves even more and do even less. As a strategy it did not work.

Anyone listening to the world at one? Derivatives, presumably worth zilch, in the so called collateral…. what chance now of a) a deal worth the name and b) a default (hidden in a restructuring, of course).

I suggest you take a closer look at the US. Helicopter Ben seems to be having a very difficult time inflating the assest he needs to inflate, real estate, but is having some luck with commodities. This creates a situation where the things one owns go down and the things one needs go up. Good luck with that.

On RTE Radio 1 today at 1pm Pat Rabitt outlined how Irish bank derivatives exposure is far greater than the banks have admitted and that this exposure will very quickly swallow up the entire Pension Reserve Fund.
He also wondered if the IMF/EU people have uncovered this situation.

Very surprisingly, Dan O’Brien of the Irish Times said he is totally unaware of this situation “but if it’s true, it’s a very worrying development.”

Greg on a previous post in reply to Colm McCarthy

“How can there be unexploded bombs at this stage?

Think minefield.

Think clusterbomb.”

It appears the derivative cluster bombs have gone off!

Was he on about gross notional or net?

Very common for big gross figures to net off to very small numbers. The risk managers at the banks should have that sorted. Er…


If the derivatives thing is true, as insinuated by the rabbit, it is unbelievable. He was suggesting that the banks used the government guarantee to try and gamble themselves out of trouble and have until now hid masive losses at the derivatives casino.

If this is true we will need to commit some funds next year to building a new jail.

@Michael Burke
You write:

That option [i.e. inflation – CG] wasn’t open to Ireland. But what was the logic behind doing the opposite – and increasing the debt burden via deflation?

I’m not quite sure what you mean by ‘deflation’ here but I presume you’re referring to the government’s austerity policy. Forgive me if I am mistaken.

So what would you have proposed that the government do? Increase public spending and raise the minimum wage, civil service pay and welfare payments to provide ‘stimulus’ by borrowing even more?

It would be interesting to learn about your supposedly less painful alternatives.

Roman Catholic Bishop Oscar Romero
we must not love ourselves too much to avoid the risks of history
election 19th January 2010
The Irish are not on the streets the Irish are on the internet
inclusive tolerant democracy must be defended, by ourselves and our near neighbours if needs be,

is mise eire, freisin

In the spirit of dignitas humanae (Rome 1965) there will be no anger we will learn, we will rebuild, no one must worry no one must be afraid

erratum humanum est

The amount of collateral that is required on derivative positions, whether they are losing or not, is dependent on the rating of the bank that sold the derivative. Anglo, at least, sold a lot of derivatives (a trading book of some 200 bn euro notional). We used to get a split of what was ‘buying’ and what was ‘selling’, but that stopped with the 2007 Anglo accounts. Meanwhile, the notional size of the Anglo book jumped 70% 2007 over 2006 and another 70% 2008 over 2007.

With the recent downgrade to junk of some, I imagine the Irish banks are all facing cash calls on their collateral.

@ Joseph

I assume that any inflating away of debt would also entail rising interest rates and even more people in Ireland being unable to afford to pay their mortgages?

My understanding of the conventional view of inflation is that it would help ease the private debt burden (including mortgages). The problem I guess for the likes of Gurdgiev in advocating this would be that it would “attack” capital in their eyes, so ist verboten.

@EWI – “it would help ease the private debt burden ”

Over the medium to long term sure but not in the first couple of years when wages are trying to catch up frog-hops in inflation. It would cause cashflow problems as you get 2-3 mortgage hikes before a wage rise kicks in.

I’m not surprised to hear our erstwhile banking colleagues may have already frittered away the nprf. If it hasn’t already gone, it will be going pretty soon as I can’t see the IMF et al allowing us to sit on a pile on one hand while drawing down with the other. They will tell us to use our own first.

Over the medium term, the bond markets catch on and apply a penal rate of interest – once inflation starts, they expect more inflation than occurs until inflation is controlled again. Hence the ECB insistence on keeping inflation expectations in check. They are, I believe, talking about the bond market, not other market participants.

@ Joseph

Over the medium to long term sure but not in the first couple of years when wages are trying to catch up frog-hops in inflation. It would cause cashflow problems as you get 2-3 mortgage hikes before a wage rise kicks in.

At our stage, all courses of action seem to involve unpleasantness. But this is the only way that occurs to me to resolve the mortgages problem at all without what amounts to another massive transfer by the State to those better able to afford it.

It is astonishing about this report re the NPRF is that it has not been denied and does not appear on RTE website as news. Is there another media blackout for some reason connected to the Ecofin meeting in Brussels this afternoon? hey certainly don’t want the approval and announcement of our loan deal derailed. They have their eyes on tomorrows markets in Spanish, Portuguese and Belgian bonds? What is going on?

@ hoganmahew

Morgan Stanley says in the US, there were three main factors in debtflation in the post-war period. First, outlays such as social security were not closely linked to inflation. Second, bondholders were surprised by inflation both after the war and in the 1970s. Third, in the first post-War decade, the average maturity of the debt was – at more than 100 months – exceptionally high.

The largest contribution of inflation to debt reduction came in the decade immediately after World War 2 (1946-1955). Despite a primary surplus of 1.2% of GDP, overall the budget was in deficit by 0.3% of GDP on average. Yet, the debt was reduced by 4.9% of GDP a year, through a nominal growth effect of 5.2% annually, as nominal GDP growth averaged 6.5% over the period. This very large nominal growth effect is mainly due to a substantial inflation effect – inflation averaged 4.2% over the period – which reduced debt to GDP by 3.7% every year, and to a much lesser extent to real GDP growth, which on average contributed 1.5% of GDP to debt reduction.

If I was a government spinner trying to reveal significant derivative losses I would:
– privately leak that there were gigantic derivative losses
then when it was alleged in the media through my leaking or anyone else leaking I would
– then slag everyone off for scaremongering
– as I publicly revealed that the losses were in fact “only” a couple of billion and completely manageable
– of course later it might be found that they were a few more billion…and a few more billion after that etc

That has been a repeated pattern in the banking catastrophe.
Claim made of big losses.
Government angrily denies then reveals “small” losses
These losses then grow and grow and grow.

Rabbitte once said he knew of a file that would rock the state regarding government collusion with the catholic church, during the 1994 Brendan Smyth extradition that brought down the government. He was widely mocked when
it didn’t turn up. But with the publication of reports of the abuse tribunals we can see that that the collusion he alleged was going on to a massively greater extent than anyone would have believed. The wiki on Albert Reynolds alledges that a CH4 documentary revealed the affair – I can’t remember- embarassing an Irish media who were silent, due to libel laws. Nothing changes.

Peston is reporting no haircuts for senior bonds and Germany holding out for 7% interest rate to placate German voters.

Oh, the irony of placating German voters with an interest rate that would have done the Treaty of Versailles justice. It was the Treaty of Versailles with its reparations which led to the inflation which brought down the Weimar republic and lead to the rise of the Nazis and the eventual Vertreibung which is such a part of the mental landscape of every modern German, for whom inflation is the ultimate bogeyman.

5.8% per annum

20 mins into RTE nees and a passing reference to the dervitaves nuke. RTE plays it down as nuffin’ new. Was our furry little rabit duped?

10billion immediate capitalization of banks.
Anyone hazard a guess as to the breakdown.
press conference very short on detail

@Oliver Vandt – “That has been a repeated pattern in the banking catastrophe”

Having had some experience in the financial services ‘communications’ area myself, I can confirm that’s a pretty normal approach. The golden rule there is only ever drip feed bad news. Drip, drip, drip. Oops, I appear to have a big puddle here now.

Pat Rabbit is no idiot. If I get the chance I will ask him about this but it might not be this side of Christmas.

@a punter
For the record, I do not want blood. Certainly not in the streets of Dublin.

That’s not something to joke about and certainly not something to sing about.

Well said.

Media blaming the markets is like blaming a wolf-pack for following its instincts.

Does no one remember the market frenzy of 1966-1973 when market-driven panic drove world currencies wild.

A new era of penal laws looms – albeit economic rather than political but all the more destructive and enslaving for that very reason.

We can and must focus on solutions to our enslavement, not just banks’ debt which has been treason has foisted upon us.

@Robert Browne
This is a disaster. What does he think he’s doing?! Has he taken professional advice on this? Has the derivatives book been valued externally?

Funny how history gets rewritten so quickly.
There’s hardly an economist standing that doesn’t claim to have foreseen the crisis and diagnosed the weaknesses of the Euro / EMU project. But sometimes the evidence doesn’t support these claims to prophetic insight.
An issue of the Journal of Common Market Studies (Dec 2003) devoted to the impact of EMU on growth and convergence was pretty upbeat. Here’s a summery of Frank Barry’s contribution:
“A critical question, then, is whether this general strong convergence at the national level will continue into the future under the EMU regime. In his
article in this volume, Barry ascribes the return to convergence to improved micro- and macroeconomic policy-making at the national level, partly in response to EU initiatives associated with the advent of EMU.” The article by Barry is silent about the issues on which he comments here.

@ P.L. Malone:
One example, among numerous others, comes from F. Barry (2001) “Fiscal Policy in EMU”, in E. Pentecost and A. van Poeck (eds.) European Monetary Integration, Aldershot: Edward Elgar:

For a severe recession that caused a 10 percent decline in the incomes of one-half of the EU, transfers to depressed regions on a scale equivalent to that available in the US would amount to 0.5% of EU GDP. This would entail a massive 50% increase in total spending on EU programmes; Eichengreen (1990). Could monetary union survive if such aid were not forthcoming from a federal EU budget? While political scientists warn that the political fabric does not exist to deliver a significantly larger EU budget, and that “subsidiarity” in any case militates against the transfer of welfare state functions to Brussels, Costa and De Grauwe (1999) have warned recently that the “failure (to create a European government with similar responsibilities to present national ones) creates the risk of the break-up of the monetary union”.

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