Another Voice for Default

Wolfgang Munchau is the latest in a growing list of influential international commentators to advocate a default on State guaranteed bank debt and/or State bonds (Irish Times article here).

I would advise the following course of action.

First, Ireland should revoke the full guarantee of the banking system, and convert senior and subordinate bondholders into equity holders.

I am aware that this would create second-level problems, in pension funds, in other banks, but it would be less costly, and more equitable, to deal with those specific problems on a case by case basis, than to dump the entire cost on the taxpayer.

The Government should then assess its own solvency position on the basis of an estimate of nominal growth of no more than 1 per cent per year for the rest of the decade. That may well be too pessimistic an assumption, but at this juncture it would be more prudent to err on the side of caution than optimism. Given the scale of the financial crisis, and its direct impact on growth, and everything we know from the history of financial crises, the case for a cautious forecast is overwhelming.

Without the load of the banking sector, such an analysis may well conclude that the Irish State is solvent. The result would depend to a very large extent on the success and extent of any bail-in programme, and the ability to contain any fall-out from such action.

If the analysis concludes that Ireland is insolvent, the Government should waste no time, and restructure the debt. Massive pressure from the EU will be brought on Ireland not to do so. But the right answer to insolvency is default – not liquidity support. Let the German government pay for the German banks, and for the recapitalisation of the European Central Bank, which may need to be refinanced under such a scenario as well.

As the momentum builds, I think it is worthwhile to recap the case for the alternative avoid default strategy. It is true that the markets no longer consider Ireland creditworthy based on fears about the size of banking losses and medium-term nominal growth. However, if Patrick Honohan is even reasonably close to being right about the size of the banking losses, and we get a half decent draw on nominal growth, then the debt to GDP ratio would stabilise under the current fiscal plan the key necessary condition for solvency.

Perhaps even more importantly, the plan secures a large package of funding support for the budget and for recapitalising the banks, and (with less certainty) an commitment from the ECB to provide a large share of the ongoing funding of Irish banks until creditworthiness can be restored. It would be good to see significant burden sharing with unguaranteed senior debt holders in Irish banks as part of the strategy, but it is likely that this would have been a deal breaker for the ECB and possibly the some European governments.

I believe there is a reasonable chance that this strategy will work to restore creditworthiness. In the meantime, we avoid a crippling sudden stop of funding to the banks and the government through international support, and are better positioned to avail of a broader European debt restructuring solution if the crisis spreads to other countries so that more radical containment measures are required. As bad as things are at present, it is important to remember that through bad policy decisions, borne of understandable frustration with soft budget constraints on investors, we could make things much worse.

I fear that Wolfgang Munchaus embrace default strategy runs a large risk of making things very much worse. Indeed, he admits that the immediate effect would be a considerable intensification of the crisis.

A default would cause havoc, no doubt, and would cut Ireland off from the capital markets for a while. But I would suspect that the shock would only be temporary. With a more sustainable level of debt, and the benefit of a real devaluation, Ireland should be able to pull through this. Once the market recognises that solvency is assured, I would bet international investors would once again be willing to lend. Even Argentina was able to gain funding from investors a few years after its default.

Hardly confidence inspiring. On balance, I think the best course is to continue to work within the present cooperative arrangements to avoid defaulting on sovereign obligations.