Barry Eichengreen recently wrote an article in a German newspaper aimed squarely at the German business and political elite, castigating them for their hesitancy and lack of generosity toward the Irish bailout. Kevin O’Rourke has provided an English translation, and has described Eichengreen’s article as “magnificent and angry.”
Reading Eichengreen’s article brings to mind a scene from the farcical American movie “The Animal House.” It might be a bit unfair to Eichengreen, and I hope that he can take a joke, but there is a connection. The movie tells the story of an out-of-control fraternity on an unnamed American college campus. In one scene, a young fraternity brother lends his most prized possession, his father’s brand-new car, to his fraternity pals for the weekend, receiving from them a solemn promise that the car will be treated with great care and returned in perfect condition. He returns from the weekend to find his father’s car destroyed, and no one willing to take responsibility or pay for the damage. The fraternity president takes the young man aside and explains that actually it is the young man’s own fault for having lent the car in the first place, delivering the classic lines “You can’t spend your whole life worrying about your mistakes. You messed up, you trusted us. Now make the best of it.”
Although written in a more austere tone, Eichengreen’s argument implicitly rests on the Animal House Defence. Germany signed up to the solemn no-bailout pledge of the Maastricht Treaty along with its European partners. Germany “messed up” in assuming that this pledge was to be trusted. So it is partly Germany’s fault that things have gone badly wrong. Now, Germany needs to acknowledge its error in putting misplaced trust in this treaty, and just quietly pay for the various member state bailouts. In Eichengreen’s argument, the same applies to German (and British, and other foreign) financial institutions. They lent money to Irish banks in the mistaken belief that it would be paid back. Much of that money was squandered during an Irish property bubble. Foreign financial institutions need to accept that they made a mistake in lending it to Irish banks in the first place, and accept that they will not be paid back. That is capitalism, where the rules are just as rough as in an American college fraternity.
The Animal House Defence probably works better in American college towns than in the suburbs of Frankfurt. I am not convinced that this type of argument will carry much traction there. A promise is a promise is more in the spirit of cultural norms among the Frankfurt set.
There has been lots of other gnashing of teeth concerning how “unfair” are the terms of the EU/IMF bailout for Ireland, and I admit the contractual terms do seem a bit tough. Like many economists in Ireland, I had trouble sleeping on the night of Sunday, November 28th, after the terms of the bailout were announced. It was surprising and disappointing that the bailout deal did not allow for renegotiation of Irish bank debt. Was it “unfair” on the Irish taxpayer to exclude Irish bank debt renegotiation as part of the bailout terms?
Fairness is an extremely difficult characteristic to tie down, since it depends so heavily on personal preferences and beliefs. But economists can trace the historical money flow associated with the Irish crisis, and this might help guide our beliefs about the fairness of the bailout terms.
The underlying cause of the Irish credit crisis can be discerned in the aggregated Irish domestic bank balance sheet, as summarized graphically here or in detail from the Irish Central Bank’s database here. The crisis arose from the fact that by Quarter 3: 2008 Irish domestic banks/building societies had built up net foreign borrowing of €158 billion, equal to 87.6% of that year’s Irish GDP. This was wildly irresponsible, and then in September 2008 the interbank borrowing market froze, and the Irish banking crisis ensued. By balance sheet definition, net foreign borrowing means that the provider of the funds is foreign and the receiver of funds is Irish. Where in Ireland did all that foreign money go? Turning to the asset side of the aggregate domestic balance sheet, we can infer that much of it went into domestic property development assets (€133 billion total assets at that date) and residential mortgages (€123 billion total assets). In terms of flow of funds, the money had been spent over the previous few years on construction costs, windfall profits for owners of Irish land and real estate, and a huge increase in Irish government tax revenues (VAT, stamp duty, associated income taxes). The spenders of the funds were mostly Irish, but the providers of these funds (by balance sheet definition) were foreign.
There is a whiff of the Animal House Defence in claiming that foreigners are now responsible for picking up the shortfall of Irish domestic bank assets and liabilities. I honestly cannot decide what is “fair” but this is a correct description of the flow of funds behind the Irish banking crisis. I am less sure than some of my colleagues about what is really “fair” in this context.
This inferred flow of funds analysis also has relevance in understanding the nature of the problem with too-high government expenditures (public pay, pensions, social welfare, etc.). Colm McCarthy repeatedly has made the point that the current level of Irish government expenditures is unsustainable since it comes out of excessive foreign borrowing. One might be led to think that this situation was different during the property bubble when high government expenditures could be paid for without foreign borrowing. But actually, tracing more carefully the flow of funds, in the property bubble period a significant proportion of Irish government expenditures were paid for indirectly by foreign borrowing. Suppose that the flow of funds generated by net foreign borrowing attracts a tax take of 40%. Then 0.40*158 billion = €63 billion worth of government expenditures during the property bubble were paid for by foreign borrowing. It was interbank (foreign institution to domestic bank) borrowing rather than sovereign borrowing, but it was foreign funds indirectly paying for Irish government expenditures. Now the Irish government might be forced by the bailout terms to pay some of that back. Not sure if that is fair or not, but there it is, in terms of inferred flow of funds and tax revenues.