I am often accused of being too optimistic about the prospects for the Irish economy. It is true I believe that if we hold our nerve with the adjustment (more on which below), and there isn’t a major deterioration in the external environment, we can get through this crisis. But my views on the appropriate strategy for getting through the crisis are at least as much determined by a fundamental pessimism about the financing vulnerabilities facing the Irish State.
It may be worthwhile to first summarise what I see as the crisis resolution strategy Ireland is pursuing. It can be summed up as adjustment with financing. I don’t think anyone disagrees that we need to make significant post-bubble adjustments: fiscal adjustments to put our debt on a sustainable path; banking adjustment to shrink the banking sector to a level consistent with feasible financing; and real adjustment to move resources from sectors with little growth potential (notably construction) to sectors with better opportunities.
Although the nature of the post-bubble economy is such that we have no choice to make these adjustments, to limit the damage from austerity and bank deleveraging to living standards it is important to make these adjustments as gradually as is feasible.
But this requires financing: financing for both the large budget deficit, and also for the banks given the insufficient availability of deposits and term funding. Since we cannot raise sufficient financing in the markets, we have been forced to rely on official sources.
(In determining the appropriate adjustment speed, we should also not forget that what we borrow now must be paid back with interest – much of it by our children who will also be asked to bear the costs of an ageing population. Deficit reduction today is not just a question of imposing hardship or not, but also how the burdens will be shared across generations.)
A central problem is that the future availability of financing is uncertain in today’s volatile international environment. This reality forces faster adjustment than would otherwise be optimal all else considered. Getting our deficit and bank funding gap down gives us the best chance of regaining our market creditworthiness. These efforts also give us the best chance of retaining the official funding that is necessary to allow us to pursue a reasonably gradual adjustment path. Moreover, a critical element of regaining market funding is that potential future lenders believe that a credible official lender of last resort is in place to give them confidence they will get their money back.
It is important not to lose sight of what a sudden stop of both market and official funding would mean: it is hard to see how it could not result in massive austerity as we have to close (at least) the primary budget deficit immediately and a likely collapse of the banking system. I think those who make simple statements about being pro or anti austerity fundamentally underestimate the vulnerability of our situation. Of course, reasonable people can disagree about the appropriate speed of the adjustment given these vulnerabilities, but it would be good to see a more appreciation in the debate about what is at stake.
Similarly, I find it hard to understand how people can make such strong statements about the desirability of not repaying the remaining unguaranteed senior bonds without showing an awareness of how close we came to a full scale bank run earlier this year. While the bank recapitalisation, deleveraging and liability guarantees are components of the strategy to stabilise the funding situation of the banks, the most critical element is the perception of the ECB/CBI willingness to act as a reliable lender of last resort. Do we really want to reopen depositor doubts about whether the ECB will support Irish banks? Indeed, I see the main function of the recapitalisation, deleveraging and guarantees as being the price that must be paid for the ECB/CBI to stand ready to play the necessary lender of last resort role. We should not let (mostly misplaced) anger at the official funders blind us to the vulnerabilities of our situation.