His WSJ article is here.
Category: Bailout
The newly-agreed programme for government is available here.
The most immediate task facing the new government will be to engage in the process of revising the euro-zone bailout mechanisms. There has been much ink spilled on the strategy the government should adopt, with threats versus persuasion the early dividing line.
I think it is fair to say that persuasion has won out for the moment. But the persuasion branch itself divides into those stressing a focus on European blame/Irish credit on one side, and those stressing shared interests in fixing broken mechanisms on the other. I would expect our European partners will listen (mostly) politely to our assertions on blame and credit, but those assertions will be ultimately dismissed as self-serving yapping.
The case for shared interests stands a better chance. It is becoming clear how flawed the bailout mechanisms are. I have previously referred to a “bailout trap”, whereby it is difficult to regain market access once a country enters a bailout. The 10-year bond yield shows the markets continue to place a high probability on a longer-term Irish default. But I think a “black hole” is actually a better analogy: not only is exiting the bailout a problem, but any country that gets anywhere close is at considerable risk of being sucked in, with Portugal most clearly in the danger zone, followed by Spain, Belgium and Italy.
Perhaps the most revealing news of last week was the threat from S&P to downgrade Portugal if EU leaders follow through on plans to impose burden sharing as part of the proposed ESM, as well as insisting on official creditor seniority (FT article here).
“We believe that if the source of external financing for the Portuguese economy were to remain restricted, the government would have to approach the EFSF to avoid an even more severe economic contraction,” . . . [Eileen X Zhang, S&P credit analyst] said.
S&P warned it would downgrade Portugal’s sovereign debt rating by one or two notches if European leaders decided later this month to require borrowers from the European Stability Mechanism – due to replace the EFSF in 2013 – to restructure their government bonds and make the ESM a preferred creditor.
Potential new private creditors see considerable risk of taking disproportionate losses in any future burden sharing, and stay well clear if there is a chance a country will succumb. But as these private creditors stay clear (and yields rise), the fear of entering the “bail-out” becomes self-fulfilling.
It is in no one’s interests to have this black hole spreading from the periphery of the euro zone, ultimately threatening its destruction. That is the case the new government should be making, and it should have no shortage of allies.
The first-order policy challenge the new government faces is to restore the creditworthiness of the State and the banks. Without market access, Ireland becomes effectively a permanent ward of the international community, continuously vulnerable to withdrawal of support, and thus in a persistent state of insecurity that undermines recovery.
To say that Ireland is not creditworthy is really just to say that markets put a high probability on an Irish default. At the moment, the cost-benefit analysis does not look favourable to a pre-emptive unilateral default, not least because of the likely backlash by official creditors including the ECB. But the high probability markets are placing on an Irish default means that the markets believe the cost-benefit calculation will shift. This could be because the perceived benefits of a future default are relatively high (say because of the high marginal cost of austerity measures), or that the costs of future default are relatively low (say because the official funders will condone and even facilitate future debt restructurings).
This places us in a bind. If it turns out that we do later have to default, it is best that it comes with as low a cost as possible. But the potential for a low-cost future default makes it impossible to raise longer-term funding now, effectively trapping us outside the markets.
Suppose, however, we could somehow raise the social costs of default (say by offering collateral on any new borrowing). This would be a double-edged sword. It would help us to credibly commit to avoid default and thus lower the market risk premium. But it would leave us facing a worse outcome in the event the benefits of default turn out to be high and the default decision is the sensible course.
But now suppose we introduce a political cost of default – costs that fall specifically on the politicians who make the default decision. This allows for a more credible commitment to avoid default while not imposing unnecessary additional social costs in the case where default actually occurs. For reasons similar to those for appointing an “inflation nut” to head a central bank, it could make sense to appoint a “default nut” as finance minister — someone who sees massive political (or even personal) cost in defaulting. The credibility of the anti-default stance could be enhanced by a promise to resign in the event default occurs – or even better to join a monastery/convent should the terrible event ever come to pass! (For this to work there would also have to be political costs to getting rid of a finance minister that refused to default, or broader political costs to the government as a whole.) One drawback of putting a “default nut” in charge of finance is that default might be or excessively delayed or avoided altogether when it is the right course. However, given how the perception of a soft restructuring down the road can trap a country outside the markets, this risk of an excessive ex post default aversion could well be a price worth paying.
The candidates for minister for finance should be falling over one another to signal to Mr. Kenny and Mr. Gilmore that default is anathema to their very being.
Governor Honohan gave a substantial interview to Richard Crowley on Prime Time last night (available here). The interview covered many of the economic and banking topics debated on this blog in recent weeks and months. If you didn’t get a chance to see it live, it is essential viewing. The interview is preceded by a report by Donogh Diamond and followed by a panel discussion with Cliff Taylor and Stephen Collins. The interview itself starts at minute 8:20 and ends at 27:35.