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.

Selling domestic or foreign assets to solve the debt crisis in Spain

In a recent paper Carmen M. Reinhart and M. Belen Sbrancia categorized major reductions in debt/GDP ratios as being achieved through: (i) economic growth; (ii) a substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation to classify the following major global episodes.



The authors then estimate the role of financial repression (i.e. a combination of inflation and negative real interest rates) in solving the post-world war II problems in selected countries shown in the following table:



The implied role played by financial repression is impressive, but its interpretation is questionable in countries like Japan and its acceptance would imply that accumulation of debt in the subsequent period 1980-2010 would be also due to absence of financial repression.

In any case, they missed (or subsumed under adjustment) one of the most important solutions for excessive debt – the sale of assets.

In the context of Spain, the insolvency of the banking system is due to a twin bubble – in real estate and in foreign acquisitions. The first is well known, but few realize the importance of the second and even see it as a source of national pride. To have an idea of the buying spree of big Spanish companies we can illustrate it with the case of Telefonica. In the last decade its CEO Cesar Alierta was a kind of Paris Hilton spending more than $85 billion in acquisitions, an amount close to the $125 billion banking bailout just agreed by the Eurozone members. Botin at Santander and other CEOs did the same.

So the Spanish creditors should demand that she sells a large portion of these foreign investments. This form of tackling desperate financial situations is not without precedents. People do not like to remember this, but the US forced Great Britain to do so to pay for war supplies at the beginning of World War II (Britain had to sell £1.1 billion in foreign assets, ¼ of all its assets).

Again, using Telefonica as an example, we recall that she currently owns €65bn of assets in Latin America which earn yearly €6bn in operating profits. Were they to be sold at book value the net effect on Spains´s balance of payments could pay for more than half of the banking recapitalization needs.

This is not a pleasant solution, but the alternative of burdening future generations with a crippled economy under unbearable unemployment and debts is not better. The Spaniards need to realize that they are not just facing a banking liquidity problem. The fundamental problem is that they need to write-off hundreds of billions of Euros lost in the real estate and foreign investment bubbles and someone must pay for them.