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Martin Wolf has an article on Iceland in today’s FT. The concluding paragraph is worth quoting in full:

they – and everybody else – must learn the really big lesson here. The combination of cross-border banking with generous guarantees to creditors is unsustainable. Taxpayers cannot be expected to write open-ended insurance on the foreign activities of their banks. It is bad enough to have to do so at home.

It was only last night that I heard that Terry Baker, formerly of the ESRI, had died on January 3rd (see http://www.esri.ie/irish_economy/quarterly_economic_commen/ ).  Readers of an older vintage will recall his role as chief contributor and editor of the  Quarterly Economic Commentary in the 1980s.  I worked as a Research Assistant with Terry on a number of these and his modus operandi was to take my numbers, tables and clumsy sentences and magically transform them into the most elegant prose.  A pretty mean table tennis player too, if I remember.  RIP.

In due course Ireland needs to have a functioning banking system which is adequately capitalised, does not impose excess costs on the productive economy, and does not enjoy any free insurance on its liabilities. The exit strategy from the guarantee is critical.

The banking problem for countries like Ireland is not addressed by the separation of commercial from investment banking – the Irish banks did’nt collapse through casino losses, but through explosive balance sheet growth and huge loan write-offs, a very old-fashioned commercial banking failure. Countries that have stood behind investment banks need to think about too-big-to-fail issues, reviving Glass-Steagal, much higher capital ratios and so forth, but this is not the Irish problem. 

Nor is it clear that, cet par, having ten commercial banks rather than three helps either. If all ten were to behave in the same way, you are in the soup anyway. The fisc ends up as lender of last resort in the Eurosystem as currently operated. But the fisc is’nt big enough to credibly underwrite the next failure in several countries, and the fisc in Iceland clearly not big enough to underwrite the last one.

Unless full-blown EMU emerges soon, with all commercial banks covered by a European FDIC with centralised European regulation and supervision, the implication is that the size of the domestic banking system which the state can stand behind must be constrained by the fiscal capacity of that state. In Ireland we got it wrong by permitting domestic bank balance sheets to expand beyond what could comfortably be supported by the fisc, and then failed to supervise them. Iceland made the same mistake muliplied by three or four. Scotland emerges as the smartest small European country, through not voting for the Nats.

The implication is that the contraction of Irish bank balance sheets is not just an important component of de-leveraging, it is necessary in order to match the state’s capacity to its responsibilities. Shifting existing assets off bank balance sheets through market transactions would complement NAMA, and help to avoid adjustment through an excessive restraint on, for example, working capital lending to private business.

It is difficult to see how an explicit deposit insurance system can be avoided, on a much bigger scale than the pre-crisis scheme. When push came to shove, it transpired that we had a much bigger scheme than we thought, and one which the banks cannot pay for. The next one should avoid any element of taxpayer subsidy.

Given the scale of the risk-to-the-fisc, commercial banking is an industry in which small European countries should plan to punch below their weight.  Shame the Irish banks were’nt bought out in a European consolidation!

The target size for the aggregate balance sheet of the domestic banks needs to be addressed in designing the exit strategy, and it would help if the Central Bank could arrange to publish a new table in the monthly bank return for guaranteed banks.

The Irish Exporters’ Association has just published its end year review for 2009. It has some useful tables showing the sectoral and destination breakdown of both merchandise and services exports – the latter are now 44% of the total. The overall picture is well known, but some of the details are revealing. While overall exports (merchandise + services) fell by just 1%, the declines were 9% for the indigenous sector, 14% for food and 21% for drink. The IEA itself concludes that when the Life Sciences sector is excluded, exports fell by €6.1 billion making it one of the worst years on record for traditional Irish manufacturers selling on export markets. It foresees 2% growth in exports next year, with most of this coming from the services sector.