Daniel Gros, Dirk Schoenmaker: a Sense of Urgency

Today’s proposals from the EU Commission on banking union offer a draft directive whose operative date would be January 1st. 2015, by which time the game will be well and truly over. It would also apply to the EU as a whole, and has that familiar, watered-down, look to it. 

Here’s a slightly more urgent suggestion from Daniel Gros and Dirk Schoenmaker:

http://www.voxeu.org/index.php?q=node/8069

In Greece, they argue, the sovereign has brought down the banks, while in Spain the banks are about to bring down the sovereign, as happened in Ireland, with a little help from the ECB.

The new ESM needs to be deployed to re-capitalise the Spanish banking system, pronto, as soon as the stress tests have been completed. Placing the burden on the sovereign, before the stress tests, is insane. We have been here before.

They also have a better idea for stopping the bank run in Greece.

The measured rise in Irish inequality

I have been meaning to comment on the results of the Survey of Income and Living Conditions (SILC) 2010, but hadn’t got around to it with all the excitement on fiscal matters.   As has been widely reported, the survey showed a dramatic increase in income inequality, with the quintile ratio (the ratio of the incomes of the highest income quintile to the lowest income quintile) rising to 5.5 from 4.3 in 2009.   The Gini coefficient also jumped dramatically, from 29.3 to 33.9.   (A Gini of 0 represent perfect equality; a Gini of 100 represents perfect inequality – i.e. one household having all the income.)  These increases more than reversed the measured declines since the middle of the decade.  

Although these increases took place at a time of wrenching adjustment in the Irish economy, the magnitude of the increases in measured inequality is still surprising.  All the more so since the ESRI’s analysis of the 2010 budget indicated that the changes were progressive (see here for an analysis of the period 2008 to 2012).  (See also page 17 of this European Commission report on Ireland.)

The SILC is an extremely carefully constructed survey.    However, as noted in the survery report, sampling variation is unavoidable, and results must be always be interpreted carefully.   One indication that sampling variation may be an issue is the fact that the number of “household heads” with a third-level qualification or higher increased to 1,830 from 1,505 (p. 83).   This increase occurred despite the total number being surveyed falling to 11,587 from 12,641.   Thus the proportion of survey respondents with a household head with a third-level education or higher – a fraction that changes relatively slowly over time – increased to 15.8 percent from 11.9 percent.  This suggests that sampling variation may explain part of the measured increase. 

My purpose here is most certainly not to diminish the importance of inequality as an issue – quite the contrary.  And it may well be true that inequality will turn out to have risen over this recession after balancing market and post-market factors.   But those concerned with inequality might be unwise to put too much emphasis on one year’s survey results.   To the extent that the increase in inequality partly reflects sampling variation, there is a greater likelihood that it will fall again in the next survey release.   This could too easily be interpreted as indicating that recession-related inequality effects are not an issue.   Perhaps of greater concern than the results in SILC 2010 is the breaking of the recent trend of progressive budgets in Budget 2012 (see Figure 1 here).   However, we will need to see more than one budget to accurately gauge the distributional implications of Government policies. 

Germany: No Deal on Ireland’s Bank Debt

Despite ratifying the Fiscal Compact by a sizable margin, which boosts the case for the Compact in other EU member states, it appears any concessions Enda Kenny hoped for on our bank debts on foot of the ratification may not materialize. Apparently any renegotiation would send a “negative signal”. From the Irish Times piece:

“We see no need for movement at the moment,” said Martin Kotthaus, spokesman for finance minister Wolfgang Schäuble.

Super.

A better deal on bank debt: What is achievable?

In the wake of the referendum result and speculation of the ESM directly injecting capital into Spanish banks, there is a lot of discussion about the possibility of Ireland “getting a better deal on its bank debt”.    It would help if people were more explicit about what they had in mind.   I would not be surprised that many in the public believe that it means there would be retrospective collective European absorption of already crystallised losses in the Irish banking system.  Although I would love to be wrong, I believe that the odds of this happening are approaching zero.   Failure to deliver such absorption would increase the sense of grievance on Ireland’s treatment in relation to the bank and bondholder/depositor rescues.   Some might argue that a sense of grievance is useful in strengthening Ireland’s bargaining position.   I doubt it; and any benefits are unlikely to outweigh the costs in reduced domestic support for Ireland’s necessary adjustment efforts.    

It is worthwhile to consider what an extension of the ESM’s role could realistically mean for Ireland.  I consider some possibilities below.   I would be interested in people’s views. 

First, if additional capital injections are needed, Ireland would have a strong case for these injections coming via the ESM.   However, this would not be a direct transfer, but a capital injection in return for a fair stake in the bank.    The advantage would be that it would reduce the uncertainty around the value of balance sheet of the State relative to State making such injections. 

Second, it is possible that the ESM could take over some or all of the State’s existing ownership stakes in the banks.  Again, I think it would be unrealistic to expect the ESM to pay more than fair value.   The advantage would again be reduced uncertainty over the value of the State’s balance sheet.   But it is again important to recognise that this would be of considerably less value than any absorption of already crystallised losses. 

Third, the fact that Ireland’s bank-rescue efforts preceded any development of the ESM as a mechanism for recapitalising banks could help Ireland get more traction on the extending the repayment schedule for the promissory notes/ELA.   (It does seem unfair to be disadvantaged for faster recognition of the reality of bank losses.)

In considering the likelihood of a deal on the promissory notes, it is worthwhile to recognise the reason for the ECB’s strong opposition.   The provision of ELA to IBRC effectively amounts to temporary monetary financing of a government.   The euro system has allowed the Irish central bank to print money to temporarily finance IBRC, but on the understanding that the funds will be repaid by the Irish State, and the money creation eventually reversed.   A monetary union could not survive with individual countries printing money on a permanent basis, as it amounts to a transfer to the country printing the money from other countries in the system.   We would and should be firmly opposed to other countries engaging in such a practice.   The ECB is therefore extremely uncomfortable with even temporary money creation.   Extending the ELA beyond the agreed schedule has, so far, been a bridge too far.   The question is whether the advantages of facilitating Ireland’s return to market creditworthiness by reducing medium-term funding needs means that they are willing to hold their noses a bit tighter and allow a longer repayment schedule.   I think there is a strong case to be made for such extended repayment schedule, but we should not be surprised that it has been so difficult. 

Fourth, an alternative to extending the maturity is for ESM to make long-term loans to the State to allow it to redeem the promissory notes.   The ECB would certainly be happy with this arrangement.   However, the benefits in terms in terms of longer maturity would have to be weighed against the higher interest rate, recognising the ultimate interest cost to the State from the promissory notes/ELA arrangement is very low.   We would have to see the details to assess whether this would be a good deal. 

What Kind of Banking Union?

It has become almost fashionable to call for a banking union to complete the monetary union. This is what I had to say in today’s Sunday Independent:

The referendum result is a relief rather than an achievement. A No vote would have made a bad situation worse. The government needs to move on quickly in exploiting whatever opportunity has been created to reduce the burden of bank-related debt imposed on the Irish Exchequer. The misfortune of Spain presents an opening, since an Irish-style response to the Spanish banking crisis is clearly unwise. The banking crisis in Spain needs a European solution and the European leadership appears to understand that Spain cannot be cut adrift to embrace unknown, and unknowable, liabilities for the debts of mismanaged banks. Ireland was SETF (Small Enough to Fail) but thankfully Spain and Italy cannot be dismissed as peripheral. It is a shocking state of affairs when European countries can see the misfortune of others as a welcome development, but this is the sad reality which has been fashioned in pursuit of the single currency project.   

 

The European Union is not structured in a way which encourages decisive management of crises. The intergovernmental nature of the Union and the inevitable reversion to national political priorities when crisis strikes create a predisposition to muddle, delay and half-measures. These features have been prominently on display since the Eurozone banking and sovereign debt crises erupted in 2008 and have seen both sets of problems intensify. One of the unambiguous lessons of history is that the costs of financial crises magnify when the policy response is too slow.

 

There have however been some potentially promising developments in the weeks leading up to the Irish referendum which received little public attention here, drowned out by the torrent of referendum babble.

 

The president of the European Central Bank, Mario Draghi, made an important speech at the European Parliament on Thursday. He described the existing Eurozone structure as ‘unsustainable’, and called for the creation of a banking union to under-write the failing currency union. The currency union has clearly lost the confidence of the markets and, more importantly, of the public, as evidenced by continuing deposit flight in several countries. Draghi is to be congratulated on his candour, a sharp contrast to the waffle and evasions of his predecessor, Jean-Claude Trichet.

 

Draghi’s remarks come in the wake of a series of speeches from ECB executive board members drawing attention to the need for centralised bank supervision and resolution, the absence of which helped to propel this country into a blind alley back in October 2010. The ECB’s behaviour on that occasion, insisting that a sovereign unable itself to borrow, should repay unguaranteed and unsecured holders of bonds issued by insolvent and closed banks, will come in time to be seen as an appalling misjudgement. Without helping the bank bond market in any discernible way, this ECB policy choice helped to undermine confidence in Eurozone sovereign debt across the board. This discretionary action by Trichet’s ECB was resisted at the time by IMF officials, whose judgement has been thoroughly vindicated by subsequent events.  

 

The popular narrative that the sovereign debt problems derive from fiscal excess may be a reasonable characterisation in the case of Greece, but Ireland and Spain ran budget surpluses through the pre-crisis period, and had amongst the lowest debt ratios in the Eurozone in 2007. It has taken far too long for European decision-makers, in particular ECB officials, to acknowledge that this is mainly a banking crisis. Regional banking crises are to be expected in a currency union. They have been a recurring feature in the United States but are dealt with at federal level, without bankrupting individual states. The failure to anticipate regional banking crises in Europe and the subsequent decision of Trichet’s ECB to prohibit haircuts for unsecured senior bank debt has turned banking crises into sovereign debt crises, weakening banks which hold sovereign bond portfolios and inserting a new short-circuit into Europe’s financial system. A circuit breaker in the form of bank resolution would have been the better option.          

 

ECB executive council member Peter Praet, speaking in Milan on May 25th. last, concluded that

 

“…….more is needed for the euro area to break the link between fiscal imbalances, financial fragmentation and financial instability. Europe needs to move towards a “financial union”, with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States”.

Two other Executive Council members, Jorg Asmussen and Benoit Coure, have expressed similar sentiments in recent speeches. The EU commission has also been working on bank resolution proposals according to newspaper leaks and a definitive document is due to be released later in June. EU Commission president Barroso has also stressed the desirability of a banking union.

Whether Europe’s single currency needs a fiscal union, for which there is little political support, is unclear, but a currency union unaccompanied by a banking union is inherently unstable (‘unsustainable’, in the admirably concise judgment of ECB president Draghi). With free capital movement, no perceived currency risk, freedom of establishment for banks and a worldwide liquidity bubble, it is clear that bank balance sheets expanded far too rapidly in several countries, including Ireland, through the pre-crisis decade. The delegation of bank supervision to national authorities and the imposition on them of the no-bank-bondholder-left-behind policy is, Greece excepted, the principal source of the sovereign debt crisis. It is also a moral hazard machine, removing market discipline from banks in countries still solvent and capable of spawning further crises in the years ahead.

The solution is not a Europe-wide bank rescue fund, which could make the moral hazard problem worse, through substituting more credible backstops for the next round of banking excess. The solution is the restoration of market discipline through exposing bank bondholders to the risk of loss. Europe’s single financial market has been sundered through deposit flight and nation-by-nation re-matching of assets and liabilities. This is no longer a monetary union in any meaningful sense – no country has departed the Euro but it has already ceased to be a trusted common currency. Further financial dis-integration can be avoided only if bank deposits in all Eurozone countries are seen as equally secure, which means a Europe-wide deposit insurance scheme, ideally funded through risk-reflective and fair premiums. Banks, including those deemed too big to fail, should be required to carry substantial bond liabilities which can be bailed-in should the banks get into trouble. If this means more expensive funding for banks, so be it. This is hardly an unintended consequence.

The common currency introduced in 1999 was poorly designed, and the failure to build a banking union to accompany the single currency was the principal weakness. It is enormously important that both the EU Commission and the ECB are now persuaded that the monetary union project is incomplete pending new structures to deal with this omission. It is Ireland’s misfortune to have been the first casualty of this design failure, largely our own fault of course, but no country should face punishment to the point of national insolvency for the sins of bank mismanagement and poor bank supervision. It is too late to lament Ireland’s decision to join the Eurozone in the first place. There is no option of painless exit, as Greece may be about to discover. Countries not already in the Eurozone are thinking twice about joining and those who stayed out are silently thankful for the foresight of their politicians. The best outcome for those already in the common currency is that the design flaws are admitted and remedied, sooner rather than later. The referendum result is welcome but the flood of admissions that the common currency needs to be re-designed is far more significant.

Creating a Europe-wide deposit insurance scheme on the hoof is challenging and there are numerous difficult issues to be addressed in the design of a new bank supervision and resolution regime. One tough question for policymakers is whether a banking union can be confined to the Eurozone or must embrace the full European Union. The banking union cannot however be long-fingered until things get back to normal. Its absence is at the heart of the current crisis.   

Vacancies at Department of Finance: Chief Economist / Head of Banking Policy

Details below.  The new position of chief economist is especially relevant in the context of the Fiscal Treaty, since key implementation issues (assessing level of potential output, evaluating feasible speed of fiscal adjustment) will require considerable technical input from the Department of Finance.