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.
26 replies on “The Animal House Defence”
If all the Irish banks had used only Irish domestic sources of funds during the bubble, would it be fair to land the general public with the bill when they collapsed? Surely not. Shareholders, bondholders, even depositors should in fairness be hit first. If a just government were in power in Ireland when this occurred they would cover depositors as far as they could and leave it at that. An unjust government taking the easy options might have done differently. Our European partners are acting unjustly towards us because it is the easiest option for them. Their banks’ investments in Irish banks – during our gigantic but completely secret property bubble – are being put on the backs of Irish taxpayers because other Europeans are selfish and ruthless. Let’s not falsely attribute some higher motivation. Animal House? This is a capitalist version of Animal Farm and Ireland is now the horse.
But perhaps if by now we had had a new government, real investigations and a transformed financial, regulatory and political culture, Europe would have been easier on us. Look at the government our establishment have left in office: reassuring everyone the IMF weren’t coming while citizens turned to the BBC to find out the truth. I bet the Europeans thought, well, if the Irish have left this government in office, they haven’t changed at all.
Who was controlling the animals in ‘Our Animal House’?
Who was resposible for bank borrowing and which organizations had the power and the responsibillty to control that private sector bank borrowing?
I would contend that private banks were responsible and that both our central bank and the ECB were the irresponsible organizations that did not do their job. However, the ECB, the Animal House prefect is now handing down punishment while ignoring its own blind eye to the recklessness that happened on its watch.
On a scale of one to ten who is the more responsible, the Irish citizenry or the ECB?
The disctinction, in this global marketplace, of Irish and non-Irish has intrigued me since these events began. I thought that there was no such thing as national borders as far as European commerce was concerned.
Your commentary states,
” By balance sheet definition, net foreign borrowing means that the provider of the funds is foreign and the receiver of funds is Irish. ”
But where in Irish law or in European Law do these definitions matter one iota?
They definitions should have mattered very much to professional investors and to the Central Bank and to the ECB for whose benefits these clearly quaisi-legal distinctions were created.
In summary therefore, the Animal House Defence is not as weak as you might suggest and is far easier to defend in law or in equity the imposition of reparations on people who had nothing to do with borrowing these funds.
If only domestic resources had been used, there wouldn’t have been such a bubble. Morgan Kelly points out that it was the availability of credit that fuelled the bubble, not just the revaluation of existing assets, hence the height of the bubble.
This is also a counter-argument to the we spent it on over-valued assets, we should pay it back, to some degree. Without the extra credit available, the bubble wouldn’t have reached the heights it did. However, this was a function of a single european financial services market which should have been controlled by both the Central Bank and behind them the ECB.
It should also be remembered that the government itself was also a significant contributor to the bubble. Between 2000 and 2009, 63 bn was spent by government on the various NDPs. These had the effect of squeezing prices, wages and the cost of land upwards, while at the same time fuelling net immigration of mobile labour distorting that fundamental driver of bubbles – demographic trends. The pressure on prices and availability of accommodation (both owning and rental) severely distorted views of the property market by even normally sensible analysts. The non-sensible ones were driven into a whipping frenzy.
This is a flatly wrong description of what has in fact happened. Under Maastricht and Lisbon (IANAL)
* Member-state bailouts are indeed forbidden
* Member-state default is not forbidden at all
* Member-state access to external assistance from the IMF (or elsewhere) is not impaired
Therefore when Greece went insolvent, it was entitled – in fact, it was obliged – under Lisbon to either get non-EU external assistance, or to restructure its sovereign debt, or both. But the other member-states – Germany emphatically included – decided that it did not please them that Greece should get IMF assistance, still less that it should restructure its debt. Therefore they pressured Greece into accepting an EU member-state bailout of precisely the kind that is forbidden under Lisbon (and on iniquitous terms, to boot). So now Germany dislikes lending money for the illegal bailouts it helped to push the Union into? It can dry its tears into Lisbon after it’s finished trampling over it.
The no-bailout clause doesn’t forbid member states from going bust: it prescribes what should (not) happen when they do. It’s the prohibitions on excessive debt and deficit which are meant to effectively prohibit member-state insolvency. Germany obviously has a right to be sore that Greece flouted those. But it would be untenable to suggest that failing to meet its debt and deficit commitments somehow takes away Greece’s sovereign right to default – it’s certainly not one of the prescribed penalties for exceeding the targets. Still less does it release Greece, or Germany, from Article 125 TFEU. And that’s aside from the fact that we’ve all had our little failings with excessive debt and deficit in the past few while, or that the other member states must have known perfectly well that Greece probably didn’t really meet the Euro entry criteria when they let it anyway.
The parallel saga of the ECB/Eurosystem is left as an exercise for the reader. Start with Article 123.1 in this case.
I take your points. The Japanese did manage to have a huge bubble though with their own currency and domestic funding but they are a very different society.
“Why do they hate us?”, used to be a popular question after 9/11. What are our sins in the eyes of Europeans and how can we put them right? Should the next government commission an EC wide opinion poll and then address their concerns comprehensively? Followed by a massive full spectrum campaign to emphasise that we have really changed?
Having read several hundred comments and articles on the morals of the Irish bailout over the past few weeks set me thinking about the applicability of Lotka’s law in this domain — a rule something to the effect that the number of interesting contributions to a subject area is approximately a cube root of the total number of contributions. Which means that the more contributions you read, the greater the likelihood that the last one you encounter will have nothing new to add to what you have already learnt. But I’m glad I didn’t throw in the towel before I read your posting. In retrospect what you say seems almost obvious. So top marks to you and all that!
One point I would like to add. In the interests of clear thinking it is absolutely essential to separate the ethical from the pragmatic dimension of the bailout issue.
Let us assume for the sake of argument that the bondholders are indeed incarnations of evil and folly.
So what do we do next? Moral suasion is unlikely to soften their hardened hearts. In fact it can safely be assumed that — as in the case of private bankruptcy law — the creditors will exploit their legal ‘wiggle room’ to the maximum. Unfair to innocent taxpayers? Their problem. From the creditors’ perspective, Ireland is a Schicksalsgemeinschaft — a community of fate, and indeed a black box whose internal workings leave them cold. There will be no mercy and no ‘compassion’ and the poor banished children of Eire will mourn and weep and send up their sighs in vain: ‘equity’ is just not part of the game. Anybody who has doubts on this front should read a WSJ headline of 23 September 2010 (US Court Rules Argentina Liable For Interest On Defaulted Bonds ). Argentina defaulted a decade ago. Enough said.
So — at least from a Macchiavellian perspective — the only outstanding question is what Ireland, as a rational debtor who is probably already destitute and acting in the worst possible faith, can ‘get away with’. If the Germans are kind enough to lend us relatively cheap money that they will never see again, so be it. If the maximum that can be extracted from the average Irish taxpayer of a bankrupt country is (say) 10000 euros per annum, and if our debts are such that we already owe more than this, it makes sense to take the 85 billion and party on until the sky falls in.
Your comparison with Animal House falls down. For it to work the guy who lent the car to his frat brothers would have to have come up with the idea of the loan of his dad’s car himself and to have been taking a fee for the service of the loan. I think you do yourself a disservice by misrepresenting someone as thoughtful as Eichengreen in such terms.
The rest of the post points out that there were some (unsustainable) benefits to Ireland from the lending, including in terms of government revenues and spending. Fair enough. All we’re arguing for is sharing the burden with the people who did that lending, i.e. the bondholders.
“So now Germany dislikes lending money for the illegal bailouts it helped to push the Union into?”
Good points. Germany seems to be the only one talking about default though? Why is this?
I think our nominally higher wages and welfare are resented by Europeans. We should stress to them that these are declining. I doubt they care about our cartels and state inefficiencies but by all means address them. So that leaves appalling financial regulation and low CT among reasons commonly advanced. Appointing Elderfield and Honohan surely isn’t enough to resolve the former. A vast amount more must be done. On tax we should look at making a long-term deal to increase CT rate – in say thirty years? But is there anything else they hate us for? Also do Euro governments have a wish list – higher income taxes for low earners, cut minmum wage – that our government is running through based on the pet Irish hates of their populations? Like Greece with its low pension age.
Unless the EU are willing to eventually restructure us then piling on more debt may make them angrier and adds to our reputational damage. It turns the whole country into a Zoe Group, rolling over our interest while knowing we can never repay. What is the feeling towards megadevelopers at the moment?
“The Japanese did manage to have a huge bubble though with their own currency and domestic funding but they are a very different society. ”
Indeed. They were rich…
Interesting concept, fairness. It all seems rather simple. The money that was borrowed from the Germans and others did not vanish into thin air. It was paid out in cash, for the most part, to sellers of real estate at unsustainable prices. So now, we have those who are owed the money and those who must pay it back. Neither of which really benefited from the transaction. But, wait, someone did benefit. The person who got the cash…
That is another issue we could, with advantage, show the Europeans we are addressing.
Is it fair that we are stuck with stumping up for deadbeat private banks, contrary to normal commercial terms, simply because we are in the EU, despite the fact that we have no treaty obligation to do so?
To follow the flow of fairness – given some the money was trousered by some people as windfall gains then why not look for some of it back?
Eichengreen has a new article out, here:
“So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured. Bank debts have to be converted into equity and, where banks are insolvent, written off. Mortgage debts, too, must be written down.
Policymakers are understandably reluctant to go down this road. Contracts are sacrosanct. Governments fear that they will lose credibility with financial markets. Where their obligations are held by foreigners, and by foreign banks in particular, writing them down may only destabilize other countries.
These are reasonable objections, but they should not be allowed to lead to unreasonable conclusions. The alternatives on offer are internal and external devaluation. European leaders must choose which one it will be. They are united in ruling out external devaluation. But internal devaluation requires debt restructuring. To deny this is both unreasonable and illogical.”
There is a place where the comparison of defaulting on some or all of banks senior debt to the Animal House defence (AHD?) falls down in that there is a character missing from the film and present in our case.
This person was not a member of the college fraternity but promised, while concussed after being hit by the car, to pay the lender’s German father for the full cost of the vehicle without being told what that price was.
This generous soul then found themselves taking out a large loan to pay for someone else’s fun, the naivety of the car’s lender, the wealth of the car lender’s father and of course their own hospital treatment.
This missing character is you, me and every Irish person we know and our Animal House reboot would have been marketed as a tragedy rather than a comedy.
European banks failed to properly evaluate the risk of lending to Irish banks and each participant in the EU wide betting consortium needs to pony up a portion of their collective losses. They will not be able to do this without state aid but it should not all be one state. I wish Eichengreen’s position was shared by more in the political and financial establishment.
Committing to gradually increasing our corporation tax until it reaches the EU average would endear us to our fellow EUropeans, I think it might present fewer (or perhaps no) problems if we tied it to a EU wide homogenization of the laws around accounting standards and tax havens where there would be considerable inertia to overcome before we had to give up the tax rate.
A bad analogy.
The guy who lent the car is a German pension fund. The fraternity was Anglo/AIB/Irish Nationwide. The EU is the University. The Irish govt is the dept the fraternity study in.
Why should the department pay for the fraternities stupidity?
Anyway, the engineering department made some strict rules on college financing, which it did not keep itself. A key university rule is not to discriminate racially, but the department of French Studies just kicked out their Roma students.
The university only applies the rules to small departments like celtic studies, but not to big departments like engineering (Germany).
We started discussing the “follow the money” taxes a couple of times before. Here’s one thread
I’ll post the second in a min.
@Jack, Bill, again
This is the other. It’s a long thread.
Even on it’s own terms, this article seems to me to make a case for burden-sharing rather than for the Irish taxpayer being saddled with complete responsibility for all of the debt.
Actually though, as noted above by Rory O’Farrell, the Animal House analogy is not a good one.
Given that as a condition of the package senior bond-holders must be “made whole,” one must wonder whether it might be cheaper to pay the confiscatory rates demanded on the open market to enable to us to deal with those bondholders in the same way subordinate bond-holders are being treated.
Or am I out of my mind?
It is a bit of stretch to use this analogy to say the least.
German banks invested in Irish banks and charged a risk premium. If the German banks charged a risk premium that was too low, that was due to their own incompetence. End of story.
It is wholly indefensible that the Irish tax-payer should have to pick up this tab.
The banking crisis could easily have been separated from the fiscal crisis at any time over the last 2 years. The govt, ECB and EU did not do so because they were weak and indecisive and in the end only concerned with saving their own reputations.
The Irish fiscal crisis could have been sorted out at this stage if it had been separated from the banking crisis and then no bail-out would have been needed. In any case, the Germans don’t have to “pay” anything – they will make a profit from the loans they will give us.
And concerning the Maastricht “no bailout clause”: the concept of no bailout, no default, no exit, is widely considered to be totally flawed and a consequence of inadequate planning on the part of the EU. Such a structure was put in place to satisfy the political preferences of the northern countries, wthtout really thinking about what it meant. It is certainly not the fault of the Irish tax-payer.
re: Committing to gradually increasing our corporation tax until it reaches the EU average would endear us to our fellow EUropeans, I think it might present fewer (or perhaps no) problems if we tied it to a EU wide homogenization of the laws around accounting standards and tax havens where there would be considerable inertia to overcome before we had to give up the tax rate.
At least we would find out who the depositors are in Anglo’s Austrian bank.
If you insist in shaking all the apples off the tree, the ones behind the bigger leaves come down as well!
Ireland is the sole author of its own misfortunes. Gov’t as a whole and in particular the regulatory agencies engaged in that time worn Irish practice of wink, nod ,nudge. Sure boysheen bawn dem rules is fur furriners dey was nuvur intended for us wese above da rules. The only weakness the Germans have is that they are honest and competent and assumed the Irish gov’t and its banks were not corrupt and incompetent. Even in our corruption we are incompetent. Similarly for the German attitude to the smorgasbord of acronyms passing as investment vehicles emanating from New York. Well respected investment banks and rating agencies all rotten to the core. To a German even world weary economists well versed in third world corruption the state of affairs in New York was shocking. Could we stop whining and complaining and look in the mirror because that is where the problem lies.
When the car rental company lent out the car it charged a rate that reflected its reckoning of the chance of damage to the car alongside its estimate of income foregone by not lending it out to another customer instead.
Where is the analogy exactly?
The Animal House story doesn’t make much of a defence.
The story ends before lawyers get involved.
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