Why the IMF therapy is not working in Ireland

After a remarkable economic success based on market capitalism, Ireland has drifted back into misery since the crisis of 2008 and risks turning into a Southern European type of state capitalism. Back in January 2011 we explained in this blog (see here) why the IMF program for Greece’s external adjustment would not work. Some of the reasons given then apply equally to Ireland (or Spain for that matter).

First, the Troika misdiagnosed the situation as a liquidity problem while in fact Ireland and Greece faced a solvency problem (albeit of a different nature).

Then, they treated the problem of excessive leverage in the wrong way. The two major mistakes in Ireland were the conversion of private debt into public debt and the reliance on internal devaluation to deleverage. It is easy to see why both policies were wrong.

Ireland had a typical situation faced by a family with irresponsible children that took excessive debt to pay for gambling losses at the Casino (or in its case to speculate in real estate). An obvious option to erase gambling debts was to default on the casino loans (in the case of the Irish real estate bubble the British and German banks). They could be charged with allowing bets that the gambler could not pay. One alternative would be to demand a debt restructuring involving partial debt forgiveness and a longer repayment period, so that with the help of family and friends (i. e. grants by national and EU institutions in the case of Irish borrowers) they could repay the remaining debt without damaging the credit of his family. Another alternative would be to ask the casino to accept an IOU without a redemption date (in case of the British and German banks accept money printed by the ECB).

Yet, the casino owners decided instead to force the collection of their loans from the children’s parents (i.e.Irish government). To save its reputation the family promised to honor the debts by putting them in their business balance sheet (the state budget in the case of Ireland). However, the debts were so huge that they would necessarily cripple an otherwise successful business (economy). It is easy to see why.

First, such an increase in leverage would bar the firm from market financing. Second, it would be forced to halt all modernization and maintenance investments. Finally, it would force the family to downsize by selling some of the best assets. Combining these three measures would inevitably lead to a lower competitiveness, declining productivity and a depressed local economy. As expected, in the last four years, investment in Ireland more than halved in real terms, while domestic demand declined by about one third.

However, the recourse to internal devaluation only made things worse. Imagine that the clientele of the parents business was mostly local (i.e. produced non-tradable goods in economists’ parlance). Therefore, cutting the wage of their workers would reduce its sales proportionally and reduce further the firms’ debt capacity.

Moreover, reducing nominal contracts in the labor market without a concomitant reduction in credit markets would inevitably lead to an increase in non-performing loans (which in 2011 indeed rose from 12% to 20%).

It is obvious that the policy of switching the debt burden from the private to the public sector only made things worse in Ireland. What we said about Greece applies equally to Ireland. It has only three options: a) to force a significant hair-cut on its bond-holders, b) to receive a major grant from other EU countries, or c) a mix of both. None of these is a pleasant solution but there is no other way out.

Is the IMF playing ostrich in Ireland?

Since December 2010, Ireland has diligently implemented an adjustment program agreed with the so-called Troika (IMF, ECB and EU). On its 6th review in June 2013, the IMF concluded that: “Ireland’s ownership of the program remains strong and policy implementation has continued to be steadfast despite the considerable challenges. All quantitative targets for the review were met, maintaining the strong performance in earlier reviews. Fiscal, financial, and structural reforms are advancing as envisaged”. Yet, the IMF seems intent on deliberately ignoring its failure (or lying), because it acknowledges in the same report “renewed tensions in the euro area have driven up Irish bond spreads, while growth remains weak and unemployment high”.

Indeed, in terms of both costs and results, the outcome is appalling. Let us look at the results first:

The chart above from the IMF report shows that the borrowing costs are higher than at the start of the program, remain at unsustainable levels and recently have resumed its rising trend. Likewise, the external debt shows no signs of abating, as shown in the next table:

The Irish net external debt position (excluding FDI and Reserves) deteriorated 16.8% (€30 billion) since the start of the program. Moreover, the government takeover of private debts has increased the general government debt from 25% of GDP in 2007 to 108% in 2011 and the IMF forecasts that it will increase to 121% of GDP in 2013.

Finally, let us look at the bank recapitalization. This program was pursued through a staggering increase of Tier I capital to 16%, but it did not solve the banking system solvability and profitability. The IMF table reproduced below shows that equity losses were still 20% in 2011, while the percentage of non-performing loans had increased from 12.1% to 19.5%.

So far for the results!

Unfortunately, the adjustment costs are equally dismal. The following table gives further details:

Suffice to say, Irish production (GNP) is still 11.8% less than it was four years ago and may fall again in 2012. Meanwhile, unemployment has reached 15% and might continue to rise despite a return to massive emigration. For instance, it is estimated that between 1976 and 2011, about 7.5% of native Irish in their twenties emigrated.

With such dismal results obtained at such an appalling cost, one must conclude that the IMF is playing ostrich in Ireland. Indeed, some observers may even wonder whether Ireland will become another Greece. So, it is not too soon to question whether the program is taking too long to work or it is fundamentally flawed.

Shameful European Leaders

In today’s news: “AP - The chief of Europe's bailout fund visited Beijing on Friday to discuss possible terms for a bond sale aimed at raising money from China and other non-European investors”.

After months of protracted squabbling over how to solve the Greek problem, all that Sarkozy and Merkel could come up with was a convoluted scheme that involves begging support from one of the remaining communist dictatorships – China.

To realize how outrageous their incapacity was, one must recall that the haircut or debt forgiveness that Greece, Ireland and Portugal needed at the start of the crisis was about 140 billion Euros, that is, the equivalent to the European Union budget for one year.

To understand how shameful it is to rely on the support of a non-democratic country, it is important to remember that China does not have a fully convertible currency, ranks 7 and 6 respectively in terms of political rights and civil liberties in the Freedom House index (a classification worse that of Iran and Rwanda) and according to Amnesty International is by far the country with the worst record in terms of executions which remain a state secret (again worse than Iran).

This is a dark episode in the history of European integration, and a shaking foundation for the future of the Euro as a currency.

Should you bet your life on a sinking ship?

Friday the Irish Times published some interesting facts about the tale of the Quinn group receivership. Mr. Quinn, a 63-year-entrepreneur, was a typical self-made millionaire who started in 1973 using a £100 loan to extract gravel he sold at a profit to local contractors and rose to become Ireland’s richest man in 2007.

In the summer of 2008, in the middle of the financial crisis, he was building up a stake of 28.5% in the Anglo Irish Bank, financed by the bank itself, and aimed at propping up the bank’s stock price. The attempt was futile and the bank ended-up being nationalized in early 2009. Quinn’s shares become worthless and he was left with €3 billion in debt secured by his business and family holdings. Anglo has now executed those guarantees and has taken over his entire group and family estate.

Similar bets were made by investors in Lehman Brothers which cost them dearly or by Warren Buffet on Goldman Sachs which made him a $3.7 billion profit. There is nothing wrong with betting on troubled companies. They are high risk investments, and as such they generate either a large pay-out or a large loss. The fundamental rule to follow is that investors must diversify their bets and should not bet more than they can lose, i.e. you should not bet your life on such investments.

So why, an experienced investor like Mr. Quinn, committed the stupid mistake of betting his fortune on Anglo? Was he blinded by greed? Or was he blinded by the lender of last resource argument that views banks as too important to go bankrupt? Probably both.

The important lesson here is not about Mr. Quinn. The important lesson here is why the Anglo was bailed out at a huge cost to the taxpayers in order to partially save some of the lenders to Anglo. This action by the Irish authorities not only left a serious burden on future generations but, most importantly, jeopardizes the future of market capitalism in Ireland by discriminating between bondholders and shareholders. Both should have suffered the full extent of their losses (100% for shareholders) and the percentage of losses incurred by bondholders and depositors. Once you start on this slippery road of saving some but not others there is no going back. Politics becomes a game of privatizing gains and socializing losses and capitalism is in danger.